The Federal Reserve System Purposes & Functions

20 Purposes and Functions of the Federal Reserve System

Function

Conducting Monetary

Policy

The Federal Open Market Committee sets

U.S. monetary policy in accordance with its

mandate from Congress: to promote maximum

employment, stable prices, and moderate long-

term interest rates in the U.S. economy.

The Federal Reserve’s Monetary Policy Mandate

and Why It Matters .............................................. 23

How Monetary Policy Aects the Economy .......................27

Monetary Policy in Practice ......................................32

Monetary Policy Implementation ................................ 38

e Federal Reserve System Purposes & Functions 21

hat is monetary policy? It is the Federal Reserve’s actions, as a

central bank, to achieve three goals specified by Congress: maximum

employment, stable prices, and moderate long-term interest rates in

the United States (figure 3.1).

The Federal Reserve conducts the nation’s monetary policy by managing

the level of short-term interest rates and influencing the availability and

cost of credit in the economy. Monetary policy directly affects interest

rates; it indirectly affects stock prices, wealth, and currency exchange

rates. Through these channels, monetary policy influences spend-

ing, investment, production, employment, and inflation in the United

States. Effective monetary policy complements fiscal policy to support

economic growth.

While the Federal Reserve’s monetary policy goals have not changed for

many years, its tools and approach to implementing policy have evolved

Figure 3.1. The Federal Reserve’s statutory mandate

The Federal Reserve conducts monetary policy in pursuit of three goals set for it by Congress. The three mandated goals are

considered essential to a well-functioning economy for consumers and businesses.

Traditional

monetary policy

Nontraditional

monetary policy

Mandate

1. Maximum employment

2. Stable prices

3. Moderate long-term

interest rates

Forward

guidance

Helps the public

better understand

policymakers’

intentions about the

future course of

monetary policy

Large-scale

asset purchases

Provide additional

stimulus to interest-

sensitive spending,

affect the economy

through the same

channels as traditional

monetary policy

Open market

operations

Inuence

supply of

balances in the

federal funds

market, supply of

money and credit

in the economy

Reserve

requirements

Inuence

demand for

balances in the

federal funds

market, supply of

money and credit

in the economy

Discount

window lending

Inuences supply

of balances in the

federal funds

market, supply of

money and credit

in the economy

22 Conducting Monetary Policy

over time. Prior to the financial crisis that began in 2007, the Federal

Reserve bought or sold securities issued or backed by the U.S. govern-

ment in the open market on most business days in order to keep a key

short-term money market interest rate, called the federal funds rate, at

or near a target set by the Federal Open Market Committee, or FOMC

(figure 3.2). (The FOMC is the monetary policymaking arm of the Fed-

eral Reserve.) Changes in that target, and in investors’ expectations of

what that target would be in the future, generated changes in a wide

range of interest rates paid by borrowers and earned by savers.

To support the economy during the financial crisis that began in 2007

and during the ensuing recession, the FOMC lowered its target for the

federal funds rate to near zero at the end of 2008. It then began to

use less traditional approaches to implementing policy, including buy-

ing very large amounts of longer-term government securities to apply

downward pressure on longer-term interest rates. In addition, the Fed-

eral Reserve’s communication of its assessment of the outlook for the

economy and its intentions regarding the federal funds rate became

a more important policy tool. In the fall of 2014, with the economy

having made substantial progress toward maximum employment, the

FOMC announced key elements of its plans for normalizing monetary

policy when appropriate. In December 2015, the FOMC decided that

economic conditions and the economic outlook warranted starting

the process of policy normalization and voted to raise its target for the

federal funds rate.

“Congress has entrusted the Federal Reserve with great responsibilities. Its decisions affect the well-being of every

American and the strength and prosperity of our nation. That prosperity depends most, of course, on the produc-

tiveness and enterprise of the American people, but the Federal Reserve plays a role too, promoting conditions that

foster maximum employment, low and stable inflation, and a safe and sound financial system.”

— Chair Janet Yellen, Nov. 14, 2013

e Federal Reserve System Purposes & Functions 23

The Federal Reserve’s Monetary

Policy Mandate and Why It Matters

The Federal Reserve was created by Congress in 1913 to provide the

nation with a safer, more flexible, and more stable monetary and finan-

cial system. The Federal Reserve Act states that the Board of Governors

and the FOMC should conduct monetary policy “so as to promote

effectively the goals of maximum employment, stable prices, and mod-

erate long-term interest rates.” This statutory mandate ties monetary

policy to the broader goal of fostering a productive and stable U.S.

economy.

The statutory mandate is achieved when most people

looking

for work are gainfully employed, and when prices for goods and

services are, on average, relatively stable. Stable prices for goods

Figure 3.2. The federal funds rate over time

The effective federal funds rate is the interest rate at which depository institutions—banks, savings institutions (thrifts), and

credit unions—and government-sponsored enterprises borrow from and lend to each other overnight to meet short-term

business needs. The target for the federal funds rate—which is set by the Federal Open Market Committee—has varied widely

over the years in response to prevailing economic conditions.

7.0

6.5

6.0

5.5

5.0

4.5

4.0

3.5

3.0

2.5

2.0

1.5

1.0

Percent

1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015

Effective federal funds rate

Target federal funds rate

Target federal funds range

24 Conducting Monetary Policy

and services contribute importantly to achieving

three economic

outcomes: (1) maximum sustainable economic growth,

(2) maximum

sustainable employment, and (3) moderate long-term

interest rates.

When the average of prices of a broad collection of goods and ser-

vices is stable and believed likely to remain so, changes in the prices

of individual goods and services serve as clear guides for

efficient

resource allocation in the U.S. economy. This then

contributes to

higher standards of living for U.S. citizens.

Moreover, stable prices encourage saving and capital formation

because when the risks of erosion of asset values resulting from

inflation—and the need to guard against such losses—are mini-

mized,

households are encouraged to save more and businesses are

encouraged to invest more.

The Federal Reserve’s other responsibilities—promoting financial system

stability (section 4), supervising and regulating financial institutions

and activities (section 5), fostering payment and settlement system

safety and efficiency (section 6), and promoting consumer protection

and community development (section 7)—contribute to the nation’s

economic well-being by supporting a smoothly functioning financial

system.

To promote public understanding of how the Federal Reserve interprets

its statutory mandate, the FOMC released its “Statement on Longer-

Run Goals and Monetary Policy Strategy” in January 2012. This state-

ment explains the FOMC’s longer-run goals and its strategy for setting

monetary policy to achieve them. In the statement, the FOMC also

established a numerical longer-run goal for inflation: In the Commit-

tee’s judgment, an annual rate of increase of 2percent in the price

index for personal consumption expenditures—an important price mea-

sure for consumer spending on goods and services—is most consistent,

over the longer run, with meeting the Federal Reserve’s statutory man-

date to promote both maximum employment and price stability. The

FOMC reaffirms its goals statement at its January meeting each year.

e Federal Reserve System Purposes & Functions 25

Low and stable inflation. Because the nation’s inflation rate over

the longer run is primarily determined by monetary policy, the Fed-

eral Reserve can work directly to ensure that the U.S. economy ben-

efits from low and stable inflation. Low and stable inflation helps the

economy operate efficiently. When inflation is low and stable, individu-

als can hold money without having to worry that high inflation will

rapidly erode its purchasing power. Moreover, households and busi-

nesses can make more accurate longer-run financial decisions about

borrowing and lending and about saving and investment. Longer-term

interest rates are also more likely to be moderate when inflation is low

and stable.

In contrast, deflation—which occurs when the prices of goods and ser-

vices are falling, on average—would increase the burden of household

and business debts after adjusting for the decline in prices. Moreover, if

inflation persisted near zero, short-term interest rates would likely also

be quite low and monetary policymakers might not be able to reduce

interest rates enough to support the economy when it is at risk of slid-

ing into recession. (Note that the terms “policymakers,” “monetary

policymakers,” and “FOMC policymakers” are used interchangeably in

this section.) As a result, monetary policy that aims to keep inflation at

2percent over the longer run helps to maintain a productive and well-

functioning economy, leading to increases in employment and to higher

standards of living for U.S. citizens. In this way, the goal of achieving

maximum employment in the economy is closely linked with the goal

of 2percent inflation.

Maximum employment. The goal of maximum employment stands

on an equal footing with price stability as an objective of monetary pol-

icy. However, policymakers recognize that factors other than monetary

policy largely determine the maximum level of employment that can

be sustained without leading to higher inflation. These factors include

trends in the size and makeup of the population, changes in the types

of jobs and skills needed in the workforce, and other policies such as

those affecting education and training. Consequently, it would not be

appropriate for the FOMC to specify a fixed goal for employment.

26 Conducting Monetary Policy

Policymakers consider a range of indicators in making their assessments

of labor market conditions consistent with maximum employment,

recognizing that those assessments are necessarily uncertain and may

change. All FOMC participants present their views on the longer-run

outlook for economic activity and unemployment four times each year,

in their Summary of Economic Projections. In those projections, partici-

pants report the unemployment rate they expect over the longer run.

For example, in the projections released in March 2016, FOMC partici-

pants’ estimates of the longer-run normal unemployment rate ranged

from 4.7 to 5.8percent, with a median estimate of 4.8percent.

The Federal Reserve’s goals for maximum employment and 2percent

inflation are generally complementary. For example, when inflation

is below 2percent and the FOMC judges that conditions in the labor

market are not as strong as those that the Committee views as con-

sistent with maximum employment, the FOMC can keep interest rates

temporarily low to promote higher employment and return inflation to

2percent. Of course, the FOMC may, at times, face situations in which

its goals are not complementary; for example, inflation might be above

2percent even as employment is below its maximum level. The FOMC

has indicated in its “Statement on Longer-Run Goals and Monetary

Policy Strategy” that, in such a situation, it would follow a balanced

approach to achieving its goals, taking into account how close or far

employment is from its maximum level and how close or far inflation is

from 2percent. (The “Statement on Longer-Run Goals and Monetary

Policy Strategy” is available on the Federal Reserve Board’s website at

www.federalreserve.gov/monetarypolicy.)

Because monetary policy actions influence inflation and employment

with a lag, the FOMC’s decisions are based on its assessments of the

medium-term outlook for the economy and the potentially different

time horizons over which employment and inflation could be expected

to return to levels consistent with the Committee’s mandate. In addi-

tion, the FOMC considers any risks associated with the economic out-

look, including risks to the financial system that could impede attaining

the Committee’s goals.

Longer-run views aid

monetary policy

FOMC participants present

their views on the longer-

run outlook for economic

activity and unemployment

four times each year in

their Summary of Economic

Projections, available on

the Federal Reserve Board’s

website at

www.federalreserve.gov/

monetarypolicy/

fomccalendars.htm.

e Federal Reserve System Purposes & Functions 27

How Monetary Policy

Affects the Economy

FOMC policymakers set monetary policy to foster financial conditions

they judge to be consistent with achieving the Federal Reserve’s statu-

tory mandate of maximum employment, stable prices, and moderate

long-term interest rates.

Monetary policy affects the U.S. economy—

and the

achievement of the statutory mandate—primarily through

its influence on the availability and cost of money and credit in the

economy.

As conditions in the economy change, the Committee adjusts mon-

etary policy accordingly, typically by raising or lowering its target for

the federal funds rate. A change in the target for the federal funds rate

normally will be accompanied by changes in other interest rates and in

financial conditions more broadly; those changes will then affect the

spending decisions of households and businesses and thus will have

implications for economic growth, employment, and inflation.

Effect of Changes in Federal Funds Rate Target

on Financial Markets and Spending

Short-term interest rates. Short-term interest rates—for example, the

rate of return paid to holders of U.S. Treasury bills or commercial paper

(a short-term debt security) issued by private companies—are affected

by changes in the level of the federal funds rate.

Short-term interest rates would likely decline if the FOMC reduced

its target for the federal funds rate, or if unfolding events or Federal

Reserve communications led the public to think that the FOMC would

soon reduce the federal funds rate to a level lower than previously

expected. Conversely, short-term interest rates would likely rise if the

FOMC increased the funds rate target, or if unfolding events or Federal

Reserve communications prompted the public to believe that the funds

rate would soon be moved to a higher level than had been anticipated.

Monetary policy: Easing

and tightening defined

The FOMC changes

monetary policy primarily by

raising or lowering its target

for the federal funds rate,

the interest rate for overnight

borrowing between banks.

Lowering the target rate

represents an “easing”

of monetary policy, while

increasing the target rate is a

“tightening” of policy.

28 Conducting Monetary Policy

These changes in short-term market interest rates resulting from a

change in the FOMC’s target for the federal funds rate typically are

transmitted to medium- and longer-term interest rates, such as those

on Treasury notes and bonds, corporate bonds, fixed-rate mortgages,

and auto and other consumer loans. Medium- and longer-term inter-

est rates are also affected by how people expect the federal funds rate

to change in the future. For example, if borrowers and lenders think,

today, that the FOMC is likely to raise its target for the federal funds

rate substantially over the next several years, then medium-term inter-

est rates today will be appreciably higher than short-term interest rates.

Generally speaking, the effect on short-term interest rates of a single

change in the FOMC’s target for the federal funds rate will be some-

what larger than the effect on longer-term rates because long-term

rates typically reflect the expected course of short-term rates over a

long period. However, the influence of a change in the FOMC’s target

for the federal funds rate on longer-term interest rates can also be sub-

stantial if it has clear implications for the expected course of short-term

rates over a considerable period.

Longer-term interest rates and stock prices. Changes in longer-

term interest rates usually also affect stock prices, and because many

individuals hold some stocks either directly or indirectly (through a

mutual fund or as part of a pension plan), the change in stock prices

will have implications for personal wealth. For example, if longer-term

interest rates decline, then investors may decide to purchase stocks,

thus bidding up stock prices. Moreover, lower interest rates may lead

investors to anticipate that the economy will be stronger and profits

will be higher in the future, and this expectation may add further to the

demand for stocks.

Dollar exchange rates and international trade. Changes in mon-

etary policy can also affect the value of the U.S. dollar in international

currency markets. For example, if monetary policy causes interest rates

to fall in the United States, yields on U.S. dollar assets will look less

favorable to international investors. With U.S. dollar assets less attrac-

Open market purchases of

longer-term securities

Prior to the 2007–09

financial crisis, the Federal

Reserve’s Open Market Desk

typically bought Treasury

securities with an average

maturity of about three

years. Since 2008, the Desk

purchased securities with

longer remaining maturi-

ties in order to increase the

effects of the purchases on

longer-term interest rates,

and purchased mortgage-

backed securities to reduce

the cost and increase the

availability of credit for the

purchase of homes.

e Federal Reserve System Purposes & Functions 29

tive, international investors may invest less in dollar-denominated assets,

lowering the value of the dollar in foreign exchange markets. A fall in

the value of the dollar will tend to boost U.S. exports because it reduces

the price that residents of other countries would need to pay in their

own currencies for U.S. goods and services. Moreover, a dollar deprecia-

tion means that U.S. residents’ purchases of imported products become

more expensive, giving U.S. consumers and firms an incentive to pur-

chase domestically produced goods and services instead of foreign ones.

Eects on wealth and spending. Regardless of whether they result

from an actual or expected change in monetary policy, the changes in

longer-term interest rates, stock prices, and the foreign exchange value

of the dollar will affect a wide range of spending decisions made by

households and businesses. For example, when the FOMC eases mon-

etary policy (that is, reduces its target for the federal funds rate), lower

interest rates on consumer loans will elicit greater spending on durable

goods (long-lasting manufactured goods) such as televisions and auto-

mobiles. Lower mortgage rates will make buying a house more afford-

able and lead to more home purchases. In addition, lower mortgage

rates will encourage homeowners to refinance their mortgages, freeing

up some cash for other purchases. For individuals holding stocks either

directly, through mutual funds, or as part of a retirement plan, higher

stock prices will add to wealth, helping to spur more spending. Invest-

ment projects that businesses previously believed would be only mar-

ginally unprofitable will become attractive because of reduced financ-

ing costs, particularly if businesses expect their sales to rise.

Degree of Slack or Overheating

FOMC policymakers, in determining the appropriate position or

“stance” of monetary policy, must assess the current and likely future

degree of slack or overheating in the economy. Because measuring the

maximum sustainable level of employment or the potential output of

the national economy is a complex undertaking, and inherent uncer-

tainties surround any particular estimate, policymakers consider a wide

range of indicators of resource utilization when thinking about appro-

priate monetary policy.

What is dollar

depreciation?

On August 15, 2008, $1

could be exchanged for

110.48 Japanese yen(¥).

Over the next several

months, the U.S. dollar

depreciated against the

yen—a period when the

FOMC was reducing its

target for the federal funds

rate. By mid-December2008,

$1 would purchase

only ¥90.68.

30 Conducting Monetary Policy

If resources are underused—for example, employment is below what

policymakers judge to be its maximum sustainable level and seems

likely to remain below—then they have scope for easing monetary

policy to move the economy to its full employment level. Conversely,

if resource utilization appears likely to remain above the level associ-

ated with maximum employment, then policymakers may judge that

a tighter monetary policy is necessary to prevent inflation from rising

above 2percent.

Other Factors Affecting Monetary Policy

Monetary policy affects the economy with a lag. Although the

channels through which the FOMC’s monetary policy decisions are

transmitted to financial conditions and the economy are reasonably

straightforward, monetary policy affects the economy with a lag. This

means that an FOMC policy decision will not change consumer or busi-

ness spending immediately. When the FOMC adjusts monetary policy,

it expects that the adjustment will affect economic conditions in the

future, and that those economic conditions will differ from what they

would have been in the absence of the policy adjustment. Thus, in

setting monetary policy, policymakers must not only evaluate current

economic conditions, they must also forecast how the economy is likely

to evolve over the next few years.

Anticipated factors. Monetary policy is not the only influence on the

economy. Many other factors can affect spending, output, employ-

ment, and inflation.

Some of these factors can be anticipated and factored into the FOMC’s

policymaking. For example, the government influences demand in the

economy through changes in taxes and spending programs, which are

often anticipated. Indeed, the economic effects of a tax cut may pre-

cede its actual implementation if businesses and households increase

their spending in anticipation of lower taxes. In addition, forward-look-

ing financial markets may build anticipated fiscal events into the level

and structure of interest rates.

e Federal Reserve System Purposes & Functions 31

Demand shocks. Other factors that affect spending on goods and

services can come as a surprise and can influence the economy in

unforeseen ways. Examples of these “demand shocks” include shifts in

consumer and business confidence or unexpected changes in the credit

standards that banks and other lenders apply when they consider mak-

ing loans. Once a demand shock is identified, monetary policy can be

used to address it.

For instance, if consumer and business confidence falter and spending

slows, the FOMC can ease monetary policy, lowering interest rates to

help move spending back up. But because data and other informa-

tion on the state of the economy are not available immediately, it can

take time before a demand shock is identified and, given that policy

actions operate with a lag, an even longer time before it is countered.

Thus, demand shocks—even ones that can be addressed by monetary

policy—can push the economy away from the Federal Reserve’s goals

of maximum employment and price stability for a time.

Supply shocks. Other shocks can affect the production of goods and

services and their prices by affecting the costs associated with produc-

tion or the technology used in production.

Examples of such “supply shocks” include crop losses due to extreme

weather and slowdowns in productivity growth relative to what would

have occurred otherwise—these sorts of adverse supply shocks tend to

raise prices and reduce output (and also employment). A disruption in

the oil market that reduces the supply of oil and increases its price sub-

stantially can also raise other prices and reduce output because oil is an

input to the production of many products. In the face of these adverse

supply shocks, FOMC policymakers can attempt to counter the loss

of output by easing monetary policy and making financial conditions

more conducive to spending; alternatively, policymakers can attempt to

counter the rise in prices by tightening policy.

32 Conducting Monetary Policy

As discussed, the FOMC has indicated in its “Statement on Longer-

Run Goals and Monetary Policy Strategy” that, in such a situation, it

would follow a balanced approach to achieving its goals, taking into

account how close or far employment is from its maximum level and

how close or far inflation is from 2percent. Of course, the economy

can also experience beneficial supply shocks, such as technological

breakthroughs or reductions in the cost of important raw materials, and

these beneficial supply shocks can both lower prices and boost output.

Monetary Policy in Practice

How are monetary policy decisions made? The members of the Board

of Governors and the presidents of the 12 Federal Reserve Banks gather

at the Board’s office in Washington, D.C., for eight regularly scheduled

meetings of the FOMC each year to discuss economic and financial

conditions and deliberate on monetary policy. If necessary, FOMC par-

ticipants may also meet by video conference at other times. The Federal

Reserve Bank of New York carries out the policy decisions made at

FOMC meetings primarily by buying and selling securities as authorized

by the FOMC.

Federal Open Market Committee Meetings

At its meetings, the FOMC considers three key questions: How is the

U.S. economy likely to evolve in the near and medium term, what is the

appropriate monetary policy setting to help move the economy over

the medium term to the FOMC’s goals of 2percent inflation and

maximum employment, and how can the FOMC effectively communi-

cate its expectations for the economy and its policy decisions to the

public? For a closer look at FOMC meeting deliberations and open

market operations, see box 3.1 and figure 3.3, respectively.

Keeping Policy in Step with Evolving Economic Conditions

As discussed, the FOMC’s overall approach to its decisionmaking is

described in its statement on its longer-run goals and its strategy for

Overview of the Federal

Reserve System and

theFOMC

See section 1 for an overview

of the Federal Reserve

System and the FOMC.

Box 3.1. What Happens at an FOMC Meeting

In preparation for each FOMC meeting, policymakers analyze economic and financial developments and update their forecasts

of economic activity, employment, and inflation over the near and medium term. The materials that they and their staffs

review include a wide range of U.S. and inter national economic and financial data, statistical and judgmental economic

forecasts, and analyses of alternative policy approaches. Participants also consult business, consumer, and financial industry

contacts to hear their perspectives on economic and financial conditions and the outlook.

The staff of the Federal Reserve Banks

collect and summarize information on

current economic conditions in their

Districts. An overall summary, com-

monly known as the Beige Book, is

released to the public one week before

the FOMC meeting. (The Beige Book is

available at www. federalreserve.gov/

monetarypolicy/beigebook/default.

htm.) At about the same time, the

staff of the Federal Reserve Board

distributes to all FOMC participants its

analysis of the economy, its economic

forecasts, and an analysis of several

policy options that span the range of

plausible monetary policy responses

to the current and expected economic

situation. Economic research groups at

the Reserve Banks separately brief their

Bank presidents on relevant economic

developments and policy choices. Using

these materials, FOMC participants for-

mulate their preliminary views on the

economic outlook and the appropriate

policy response in preparation for their

meeting in Washington.

During the first part of the meeting, the

Federal Reserve governors and Reserve

Bank presidents receive briefings that

review the operations of the System

Open Market Desk at the Federal

Reserve Bank of New York and recent

economic and financial developments

in the United States and abroad. Each

Bank president around the table then

takes a turn presenting his or her views

on economic conditions in his or her

District, and both the presidents and

governors offer their assessments of

recent developments and the outlook.

After a staff presentation on options

for monetary policy, participants again

share their individual judgments of how

policy should be conducted over the

period prior to the next FOMC meet-

ing, how they expect policy to evolve

over the medium run, and how the

Committee’s policy intentions should be

communicated to the public. While all

participants are included in the discus-

sions, the policy decision rests with the

voting members of the FOMC—the

members of the Board of Governors,

the president of the Federal Reserve

Bank of New York, and four of the

Bank presidents (on a rotating basis).

For more information on the FOMC

and other key Federal Reserve entities,

see section 2. For an in-depth look at

what happens at an FOMC meeting,

see the speech that former Federal

Reserve Governor Elizabeth A. Duke

delivered in October 2010, “Come

with Me to the FOMC,” available at

www.federalreserve.gov/newsevents/

speech/duke20101019a.htm.

e Federal Reserve System Purposes & Functions 33

setting monetary policy to achieve them. In practice, however, selecting

policy tools to implement the FOMC’s policy strategy is not clear cut.

The U.S. and global economies are complex and evolving, and changes

in monetary policy take time to affect economic activity, employment,

and inflation.

Moreover, monetary policy is just one of the factors determining the

pace of domestic economic activity, employment, and inflation. Accord-

ingly, in making their assessment of how the economy is likely to evolve