What is ‘Monetary Policy’
Monetary policy consists of the actions of a central bank, currency board or other regulatory committee that determine the size and rate of growth of the money supply, which in turn affects interest rates. Monetary policy is maintained through actions such as modifying the interest rate, buying or selling government bonds, and changing the amount of money banks are required to keep in the vault (bank reserves).
The Federal Reserve is in charge of monetary policy in the United States.
BREAKING DOWN ‘Monetary Policy’
Broadly speaking, there are two types of monetary policy, expansionary and contractionary. Expansionary monetary policy increases the money supply in order to lower unemployment, boost private-sector borrowing and consumer spending, and stimulate economic growth. Often referred to as “easy monetary policy,” this description applies to many central banks since the 2008 financial crisis, as interest rates have been low and in many cases near zero.
Contractionary monetary policy slows the rate of growth in the money supply or outright decreases the money supply in order to control inflation; while sometimes necessary, contractionary monetary policy can slow economic growth, increase unemployment and depress borrowing and spending by consumers and businesses. An example would be the Federal Reserve’s intervention in the early 1980s: in order to curb inflation of nearly 15%, the Fed raised its benchmark interest rate to 20%. This hike resulted in a recession, but did keep spiraling inflation in check.
Central banks use a number of tools to shape monetary policy. Open market operations directly affect the money supply through buying short-term government bonds (to expand money supply) or selling them (to contract it). Benchmark interest rates, such as the LIBOR and the Fed funds rate, affect the demand for money by raising or lowering the cost to borrow—in essence, money’s price. When borrowing is cheap, firms will take on more debt to invest in hiring and expansion; consumers will make larger, long-term purchases with cheap credit; and savers will have more incentive to invest their money in stocks or other assets, rather than earn very little—and perhaps lose money in real terms—through savings accounts. Policy makers also manage risk in the banking system by mandating the reserves that banks must keep on hand. Higher reserve requirements put a damper on lending and rein in inflation.
Unconventional Monetary Policy
In recent years, unconventional monetary policy has become more common. This category includes quantitative easing, the purchase of varying financial assets from commercial banks. In the US, the Fed loaded its balance sheet with trillions of dollars in Treasury notes and mortgage-backed securities between 2008 and 2013. The Bank of England, the European Central Bank and the Bank of Japan have pursued similar policies. The effect of quantitative easing is to raise the price of securities, therefore lowering their yields, as well as to increase total money supply.
U.S. Federal Reserve
Most central banks are independent from other policy makers. This is the case with the Federal Reserve and Congress, reflecting the separation of monetary policy from fiscal policy. The latter refers to taxes and government borrowing and spending.
The Federal Reserve has what is commonly referred to as a “dual mandate”: to achieve maximum employment (in practice, around 5% unemployment) and stable prices (2-3% inflation). In addition, it aims to keep long-term interest rates relatively low, and since 2009 has served as a bank regulator. Its core role is to be the lender of last resort, providing banks with liquidity in order to prevent the bank failures and or panics in the financial services sector.