FED101 - Policy Basics
What is monetary policy?

The term "monetary policy" refers to what the Federal Reserve, the nation’s central bank, does to influence the amount of money and credit in the U.S. economy. What happens to money and credit affects interest rates (the cost of credit) and the performance of the U.S. economy.

What is inflation and how does it affect the economy?

Inflation is a sustained increase in the general level of prices, which is equivalent to a decline in the value or purchasing power of money. If the supply of money and credit increases too rapidly over many months, the result will be inflation. With inflation, a dollar buys less and less over time.

Here are some examples of how inflation can hurt businesses or individuals:

-- Inflation might make people worse off if their incomes don’t rise as rapidly as prices.

-- Lenders might lose because they will be repaid with dollars that aren't worth as much.

-- Savers might lose because the dollar they save today will not buy as much when they are ready to spend it.

-- Businesses will find it harder to plan and therefore may decrease investment in future projects.

-- Owners of financial assets suffer.

-- Interest rate-sensitive industries, like mortgage companies, may suffer as inflation drives up long-term interest rates and Federal Reserve tightening raises short-term rates.

What are the goals of monetary policy?

The goals of monetary policy include the promotion of sustainable economic growth, full employment, and stable prices. Through monetary policy, the Fed is most able to maintain stable prices, thereby promoting economic growth and maximum employment.

What are the tools of monetary policy?

The Federal Reserve’s three instruments of monetary policy are open market operations, the discount rate and reserve requirements.

Open market operations involve the buying and selling of U.S. government securities (federal agency and mortgage-backed). The term "open market" means that the Fed doesn’t decide on its own which securities dealers it will do business with on a particular day. Rather, the choice emerges from an "open market" in which the various securities dealers that the Fed does business with—the primary dealers—compete on the basis of price. Open market operations are flexible and thus, the most frequently used tool of monetary policy.

The discount rate is the interest rate charged by Federal Reserve Banks to depository institutions on short-term loans.

Reserve requirements are the portions of deposits that banks must maintain either in their vaults or on deposit at a Federal Reserve Bank.

How are open market operations used to implement monetary policy?

Open market operations are the primary tool used to regulate the supply of bank reserves. This tool consists of Federal Reserve purchases and sales of financial instruments, usually securities issued by the U.S. Treasury, Federal agencies and government-sponsored enterprises. Open market operations are carried out by the Domestic Trading Desk of the Federal Reserve Bank of New York under direction from the FOMC. The transactions are undertaken with primary dealers.

The Fed’s goal in trading the securities is to affect the federal funds rate, the rate at which banks borrow reserves from each other. When the Fed wants to increase reserves, it buys securities and pays for them by making a deposit to the account maintained at the Fed by the primary dealer’s bank. When the Fed wants to reduce reserves, it sells securities and collects from those accounts. Most days, the Fed does not want to increase or decrease reserves permanently so it usually engages in transactions reversed within a day or two. That means that a reserve injection today could be withdrawn tomorrow morning, only to be renewed at some level several hours later. These short-term transactions are called repurchase agreements (repos) – the dealer sells the Fed a security and agrees to buy it back at a later date.

What is the role of the Federal Open Market Committee (FOMC)?

The FOMC formulates the nation's monetary policy. The voting members of the FOMC consist of the seven members of the Board of Governors (BOG), the president of the Federal Reserve Bank of New York and presidents of four other Reserve Banks who serve on a one-year rotating basis. All Reserve Bank presidents participate in FOMC policy discussions whether or not they are voting members. The chairman of the Board of Governors chairs the FOMC.

The FOMC typically meets eight times a year in Washington, D.C. At each meeting, the committee discusses the outlook for the U.S. economy and monetary policy options.

In preparing for the meetings, FOMC members are briefed on economic conditions by members of their staffs. Also, before each meeting, they receive the "Green Book," which contains the Federal Reserve Board staff forecasts of the U.S. economy, the "Blue Book," which presents the Board staff’s analysis of monetary policy alternatives and the "Beige Book," which includes a discussion of regional economic conditions prepared by each Reserve Bank. Only the Beige Book is available to the public, and it is released approximately two weeks before each FOMC meeting.

What occurs at an FOMC meeting?

A senior official of the Federal Reserve Bank of New York discusses developments in the financial and foreign exchange markets, along with the details of the activities of the New York Fed's Domestic and Foreign Trading Desks since the previous FOMC meeting.

Senior staff from the Board of Governors (BOG) present their economic and financial forecasts.

Governors and Reserve Bank presidents (including those currently not voting) present their views on the economic outlook.

The BOG’s director of monetary affairs discusses monetary policy options (without making a policy recommendation.)

The FOMC members, beginning with the chairman, discuss their policy preferences.

The FOMC votes.

How is the FOMC's policy formulated?

Monetary policy is formulated in terms of a target for the federal funds rate, the interest rate that banks charge one another for overnight loans. The federal funds rate is sensitive to changes in the demand for and supply of reserves in the banking system and thus provides a good indication of tightness or ease in monetary conditions.

At the conclusion of each FOMC meeting, the Committee issues a directive to the New York Fed's Domestic Trading Desk that guides the implementation of the Committee's policy through open market operations. In addition, the FOMC states whether economic and financial conditions pose a greater risk to price stability or to sustainable growth. The post-FOMC meeting announcements also report on discount rate changes, which are generally less frequent than changes in the target for the federal funds rate.

The minutes of each FOMC meeting are published approximately six weeks later, a few days after the following meeting, and are readily available to the public. Occasionally the FOMC makes a change in monetary policy between meetings.

While the Federal Reserve Bank presidents discuss their regional economies in their presentations at FOMC meetings, they base their policy votes on national, rather than local, conditions. In recent years, FOMC decisions generally have been unanimous or nearly unanimous.

Why does the Fed typically conduct open market operations several times a week?

The vast majority of open market operations are not intended to carry out changes in monetary policy. Instead open market operations are conducted on a daily basis to prevent technical, temporary forces from pushing money and credit conditions in an undesired direction. For example, the amount of cash in people’s possession varies depending upon the season of the year, the day of the month, and even the day of the week. When people hold more cash, the reserves that banks have available to lend to the banking system go down. That could push the fed funds rate up, if the Fed didn’t intervene by adding reserves using open market purchases of securities.

How does the Fed conduct open market operations?

Before conducting open market operations, the staff at the Federal Reserve Bank of New York collect and analyze data and talk to banks and others to estimate the amount of bank reserves to be added or drained that day. They then confer with Fed officials in Washington who do their own daily analysis and reach a consensus about the size and terms of the operation. Then a New York Fed official sends a message to over twenty securities dealers to detail the Fed’s intention to buy or sell securities. Fed officials expect these dealers to respond within minutes. Then they take another few minutes to accept or reject a dealer’s offer.