Monetary policy is the decisions and actions taken by a central bank to achieve its goals, which usually consist of promoting economic growth, job creation and low inflation and interest rates. In the U.S., for example, the Federal Reserve is guided in its monetary policy by its mandate from Congress, which is to promote "maximum employment, stable prices, and moderate long-term interest rates." Most central banks around the world, such as the European Central Bank, the Bank of England and the Bank of Japan, largely have the same priorities.
The main mechanism available to central banks for executing monetary policy is influencing the level of interest rates—i.e., the cost of money—and the amount of money available to lend to businesses and consumers.
- An "easy" or "accommodative" monetary policy means the central bank is keeping interest rates low and trying to make more money available in order to encourage economic activity.
- However, if the central bank deems that the economy is growing too fast, which can create hyperinflation, it "tightens" monetary policy by raising rates and restricting the flow of money available for lending.
Central banks execute monetary policy through a variety of pronouncements of their intentions as well as actions in the marketplace to implement those goals.
In the U.S., for example, the Federal Open Market Committee (FOMC) is the Fed's monetary policymaking unit. It sets the federal funds rate, its benchmark interest rate, which is the interest rate banks pay to borrow and lend money to each other overnight that they hold on deposit at the Fed. This rate has a profound effect on the general level of interest rates for businesses, consumers and governmental entities throughout the economy, both short- and long-term.
The FOMC is composed of 12 members. These are the seven members of the Fed's Board of Governors and five of the 12 presidents of the regional Federal Reserve banks, one of whom is the president of the Federal Reserve Bank of New York, and vice chairman of the committee and a permanent member. The chairman of the Fed is also the chairman of the FOMC. The presidents of the other regional Fed banks take turns filling the remaining four voting seats.
The FOMC has eight scheduled meetings a year, at which the members discuss current and expected economic conditions and decide to raise, lower or hold steady the fed funds rate, which it announces to the public. In between meetings, Fed members often try to influence interest rates through speeches, Congressional testimony, media interviews and other public pronouncements.
Implementing Monetary Policy
In addition to these public pronouncements, the Fed has three tools to implement its monetary policy: open market operations, the discount rate, and reserve requirements. The FOMC is responsible for open market operations, while the Fed board of governors is responsible for the other two functions.
Open market operations (OMOs), which are conducted through the New York Fed, include the purchase and sale of securities by the Fed in the open market. There are two types of OMOs: temporary and permanent.
- The Fed uses temporary OMOs to keep the fed funds rate in the target range established by the FOMC. These consist of either repurchase agreements (repos) or reverse repurchase agreements (reverse repos or RRPs). In a repo, which is essentially a collateralised loan, the Fed buys a security, usually a Treasury bond, and agrees to sell it back to the owner at a specified higher price. The Fed does this to add temporary reserves to the financial system. In a reverse repo, the Fed sells a security and agrees to buy it back later, in effect draining reserves from the system.
- Permanent OMOs involve outright purchases or sales of securities for the Fed's portfolio. During and after the financial crisis, after it had cut the fed funds rate to zero with little effect on the economy, the Fed bought trillions of dollars of U.S. Treasury securities and government-insured mortgage-backed securities in order to try to drive down long-term interest rates in the overall market and to make financial conditions more accommodative. The Fed has stopped its purchases of these securities and is reducing its portfolio by allowing those bonds to run off as they mature.
The Discount Rate And Reserve Requirements
In addition to the fed funds rate, the Fed sets the discount rate. This is the interest rate commercial banks and other depository institutions pay to borrow from the Fed's regional banks, which banks use as a backup source of liquidity. By lowering the discount rate, the Fed makes it cheaper to borrow, thus encouraging lending and spending by consumers and businesses. Raising the discount rate should have the opposite effect by making borrowing more expensive.
The Fed is also empowered to set banks' reserve requirements, which are the amount of deposits that banks must hold in cash, either in their vaults or on deposit at their regional Fed bank. By lowering the reserve requirements, banks have more money to make loans, while raising them has the reverse effect.
The Money Supply
The Fed also has some level of control over the amount of money circulating in the economy, which can also impact interest rates. An abundant supply of money generally equates with low interest rates, while a tighter supply would make it more expensive to borrow.
The Fed has "complete" control over one part of the money supply, namely the monetary base, which is currency in circulation plus banks' reserve balances held at the Fed. The Fed controls the monetary base through open market operations. By buying securities, it adds to bank reserves and increases the monetary base, which generally has the effect of lowering interest rates. Conversely, by selling securities, the Fed decreases a bank's balance at the Fed and thus the amount of money it has to lend to the public, which makes borrowing costs more expensive.
Compared to the past, the money supply has lost some of its importance as a guide for central banks, including the Fed, to conduct monetary policy. The FOMC still takes money supply data into consideration while conducting monetary policy, but only uses it as "part of a wide array of financial and economic data."
Monetary policy is the means by which central banks try to achieve their goals, which usually consist of promoting economic growth, job creation and low inflation and interest rates. They do this through a combination of raising and lowering interest rates and open market operations, buying and selling securities to increase or decrease the amount of money available for lending. An "easier" or "accommodative" monetary policy consists of low interest rates and abundant money for lending, while a "tighter" or "restrictive" policy means higher rates and less money for lending in order to choke off inflation.
Senior Market Specialist
Russell Shor (MSTA, CFTe, MFTA) is a Senior Market Specialist at FXCM. He joined the firm in October 2017 and has an Honours Degree in Economics from the University of South Africa and holds the coveted Certified Financial Technician and Master of Financial Technical Analysis qualifications from the International Federation…