Healthy economies require healthy currencies, so it is imperative for economic policy to maintain a healthy currency. Money plays an important role in any economy as a medium of exchange and a store of value. For an economy to function, money needs to effectively serve these two functions. However, the value of money changes over time and sometimes its value can change dramatically. Prices can rise quickly when demand for goods and services is high or slowly when demand is low. We refer to this increase in prices as inflation. Inflation that is too high (hyperinflation) or negative (deflation) is not good for an economy, because it can distort economic and financial decisions. When the value of money is losing value or gaining value too quickly, money no longer functions as an effective medium of exchange or store of value.

Central banks exist to manage the value of currencies. Goods and services in an economy are typically priced in the local currency. The level of prices will depend on the demand for goods and services as well as the supply of money. The central bank can adjust the supply of money to manage the rate of inflation.

The Federal Reserve (the “Fed”) is the central bank of the United States. The Federal Reserve was established in 1913. Its original purpose was to serve as a lender of last resort. A lender of last resort lends money to solvent institutions that have no access to the private funding market. The structure of the Federal Reserve is an interesting balance of federal and regional power. The Federal Reserve System is governed by the Federal Reserve Board of Governors in Washington D.C. and there are 12 Reserve Banks located in cities across the country (Map of the Federal Reserve Districts). The Federal Reserve Bank of Chicago is the regional Reserve Bank for district 7-G in the Midwest. The seven governors in Washington are appointed by the President of the U.S. and confirmed by the U.S. Senate. The chair of the Federal Reserve serves a four-year term.

The Federal Reserve is called the Federal Reserve, because it holds reserves for U.S. banks. Reserves are money that banks hold in reserve at the Federal Reserve. You can think of reserves as deposits that banks make at the Fed. When banks receive deposits, they lend out some of the money and they hold some of the money in reserves. The United States has a fractional reserve system, which means that banks hold a fraction of their deposits in reserves. Required reserves are reserves that banks are required to hold at the Federal Reserve for safety purposes. If a bank does not have sufficient reserves and depositors withdraw money, the bank can become illiquid. Excess reserves are reserves that banks hold at the Federal Reserve that are in excess of the required reserves. Banks with insufficient reserves can borrow reserves from other banks in the interbank market for “federal funds.” The interest rate for banks to borrow reserves from other banks is called the federal funds rate (see below).

Monetary policy is the policy of the central bank that determines the money supply. It is helpful to think of central banks as entities that use monetary policy to maintain low and stable inflation. Monetary stimulus (or “loosening”) is an expansion of monetary policy and monetary contraction (or “tightening”) is a contraction of monetary policy. Monetary stimulus tends to increase inflation, whereas monetary contraction tends to reduce inflation.

It is important to distinguish monetary policy from fiscal policy. Monetary policy is controlled by the central bank for the purpose of managing the money supply. Fiscal policy is controlled by Congress for the purpose of managing federal spending. When the government spends more than it is collecting in tax revenue, the government is providing fiscal stimulus. Fiscal stimulus increases the government deficit and requires the government to borrow, thereby increases government debt. The U.S. Treasury issues Treasury bills, notes, and bonds to finance the government deficit. In 2020, the CARES Act is an example of fiscal stimulus. The Federal Reserve purchases U.S. government debt as part of monetary policy, but it does not issue government debt. The term reflation is often used to refer to economic recovery (and associated rising prices) that is supported by monetary and fiscal stimulus.

The Federal Open Market Committee (FOMC) is a committee of the Federal Reserve that sets monetary policy. The FOMC’s main policy tool is the federal funds rate. The FOMC consists of the Federal Reserve governors and a rotating combination of Reserve Bank Presidents. The committee is designed to have seven voting governors and five voting presidents, for a total of twelve voting members. The voting presidents rotate every year. The President of the Federal Reserve Bank of New York is the vice chair of the FOMC and always votes. This is because the New York Fed implements open market operations by transacting (buying and selling securities) with large, global banks called primary dealers. The FOMC meets eight times per year (about every six weeks). Upcoming FOMC meetings and their outcomes are posted on the FOMC Calendar. At the end of each meeting, the FOMC releases a “FOMC Statement.” At certain meetings, the FOMC also releases “Projection Materials” that include their outlook for the economy and future monetary policy (called “forward guidance”).

The FOMC votes on open market operations, which are the actions of the Federal Reserve that determine monetary policy. In an open market purchase, the Federal Reserve purchases securities from banks in exchange for reserves. In an open market sale, the Federal Reserve sells securities to banks in exchange for reserves. An open market purchase increases reserves in the banking system (injects liquidity) and an open market sale reduces reserves in the banking system (drains liquidity). In conventional monetary policy, the central bank buys and sells short-term government securities in open market operations. In the U.S., the Federal Reserve implements conventional monetary policy by buying and selling U.S. Treasury Bills (short-term U.S. government debt).

The monetary policy of the Federal Reserve follows a “dual mandate.” The dual mandate is the two mandates of the Federal Reserve: (1) price stability and (2) maximum employment. The Federal Reserve must balance these two mandates. The FOMC has defined price stability as a goal that “inflation averages 2 percent over time and longer-term inflation expectations remain well anchored at 2 percent.” This goal is applied to core inflation, which is inflation excluding food and energy. These two categories are excluded because their prices are quite volatile. Inflation that includes food and energy is sometimes referred to as headline inflation. Maximum employment does not have an explicit definition. It is low unemployment, but not “full employment.” It is closely related to the Non-Accelerating Inflation Rate of Unemployment (NAIRU), which is the level of unemployment that does not cause inflation to rise too much. The Phillips Curve is an economic theory that inflation and unemployment have a stable and inverse relationship (when unemployment falls, inflation rises). In recent years, global economies have been characterized by low unemployment and low inflation, which has raised some questions about the Phillips Curve.

The goal of monetary policy is to have a stable economy. You can think of it as a “Goldilocks” economy that is “not too hot” and “not too cold.” When the economy is too hot, the central bank uses monetary contraction to cool down the economy. When the economy is too cold, the central bank uses monetary stimulus to heat up the economy. In this way, the central bank attempts to reduce the tendency toward economic booms and busts. This can be thought of as smoothing out the business cycle. By reducing the volatility of GDP growth, the central bank attempts to foster long-term, stable growth. This process of “managing the economy” has had debatable success. There are those who favor the views of Friedrich Hayek, who argues for more of a laissez-faire economy (hands off) and those who favor the views of John Maynard Keynes for a managed economy. Here is funny video that depicts this debate in rap form. This has been a particularly intense debate recently among activist investors who argue that financial markets are now driven by Fed decisions rather than business fundamentals.

Some central bankers tend to focus more on inflation and some tend to focus more on employment (growth). A hawk is a central banker who wants to fight inflation and is more ready to implement monetary contraction to do so. A dove is a central banker who wants to support employment (growth) and is more ready to implement monetary stimulus to do so. These are terms related to foreign policy for fighting (hawk) and seeking peace (dove).

The federal funds rate is the interest rate in the interbank market for federal funds. This is the primary tool of the modern FOMC for setting monetary policy. When the FOMC lowers the federal funds rate, the Federal Reserve is expanding monetary policy (monetary stimulus). When the FOMC raises the federal funds rate, the Federal Reserve is contracting monetary policy (monetary contraction). The Federal Reserve lowers the federal funds rate using an open market purchase and the Federal Reserve raises the federal funds rate using an open market sale. How do open market operations achieve the Federal Reserve’s target rate for the federal funds rate? Open market purchases increase the reserves in the banking system, reducing the cost for banks to borrow reserves from one another, thereby reducing the federal funds rate. Inversely, open market sales reduce reserves in the banking system, increasing the cost of borrowing reserves and increasing the federal funds rate. In other words, the Federal Reserve uses open market operations to control the supply of reserves in the banking system and thereby the federal funds rate.

The current federal funds rate range is 0 to 1/4 percent. This is referred to as the “zero lower bound.” The Federal Reserve has opted to not implement negative interest rates. Other central banks, including the European Central Bank and Bank of Japan, have implemented negative interest rates as an additional measure of monetary stimulus. With negative interest rates, banks are paid to borrow money, which is intended to incentivize banks to lend more money to firms and households. However, there is significant debate about the pros and cons of negative interest rates.

During the financial crisis of 2008-2009, central banks began using tools beyond short-term interest rates. Unconventional monetary policy is the use of monetary tools that are not part of the central bank conventional tool kit. The best example of this is quantitative easing. Quantitative easing (QE) the purchase of long-term securities by central banks for the purpose of monetary stimulus. QE is a form of open market purchase, but the securities are long-term rather than short-term. The most basic form of QE is the purchase of long-term Treasury bonds by the Federal Reserve for the purpose of reducing long-term interest rates. The Federal Reserve increases the demand for Treasury bonds, which increases Treasury prices and lowers Treasury yields (interest rates). As a form of open market purchase, QE increases reserves in the banking system (similar to lowering the federal funds rate). The Federal Reserve began quantitive easing in 2008 and implemented three rounds of easing (QE1, QE2, and QE3) in the years immediately following the financial crisis. This was intended to support the post-crisis economic recovery. The Federal Reserve has re-started quantitative easing during the 2020 COVID crisis.

Quantitative easing can involve the purchase of non-government assets. During the financial crisis, the Federal Reserve also purchases mortgage- backed securities (MBS). The purpose of buying MBS was to reduce mortgage costs and stimulate the U.S. housing market. The financial crisis was also the beginning of central banks buying private sector financial securities. The European Central Bank purchased corporate bonds and the Bank of Japan purchased corporate stocks. These measures to support specific financial markets were considered highly unconventional at the time. However, the Federal Reserve has begun purchasing some forms of private assets in 2020 as well.

Quantitative easing is not as easy to measure as the federal funds rate. One way to measure quantitive easing is the monetary base. The monetary base is the sum of currency (in M1) and reserves. You can think of it as money in the form of cash and money in the form of deposits that banks have at the Fed. As the Fed increases quantitative easing, it increases open market purchases and reserves in the banking system, which increases the monetary base. As a result of quantitative easing, the monetary base in the U.S. has expanded dramatically since 2008. Reserves are a liability of the Federal Reserve (a deposit of banks at the Fed), so the expansion of reserves has also resulted in the Federal Reserve having a much larger balance sheet. There is now some debate about whether the balance sheets of major central banks around the world have grown too large as a result of quantitative easing.

As a reminder, there are many central banks around the world. Central banks are associated with sovereign, fiat currencies. Most developed economies have central banks to manage the currency. The European Central Bank (ECB) is the central bank of the European Area that uses the Euro. The Bank of Japan (BoJ) is the central bank of Japan that manages the value of the Japanese Yen. Some central banks are government agencies (e.g., the European Central Bank), whereas others are privately owned (e.g., Swiss National Bank).

Independent central banks are essential to stable monetary policy. An independent central bank is a central bank that operates independently of elected government offices. In other words, the central bank’s decisions are not influenced by elected government officials. This is important, because elected governments tend to want high, short-term economic output. One means to achieve this end is through expansive monetary policy. However, expansive monetary policy tends to increase inflation in the longer-term. Research has shown that long-term inflation is positively associated with increases in money growth. Therefore, government influence in monetary policy is often not good for the economy in the long-term.

While there is still strong support for independent central banks, some elected officials have raised questions about this approach to central banking. Is it possible for a central bank to be too independent? During the financial crisis, the Federal Reserve introduced a range of new programs that raised questions about the limits of its authority. Some members of the U.S. Congress argued that the Federal Reserve should be more accountable to representative government. As central banks have become more active in supporting economies, some worry that central banks have become too powerful.

Glossary

Central bank. An entity that manages the value of a sovereign, fiat currency.

Dual mandate. The two mandates of the Federal Reserve: (1) price stability and (2) maximum employment

Federal Reserve. The central bank of the United States.

Independent central bank. A central bank that operates independently of elected government offices

Monetary policy. The policy of the central bank that determines the money supply