How does monetary policy influence inflation and employment? Why does the Federal Reserve aim for 2 percent inflation over time? What is the lowest level of unemployment that the U.
Search Submit Search Button. Toggle Dropdown Menu. Search Search Submit Button Submit. Share RSS. The FOMC has the ability to influence the federal funds rate--and thus the cost of short-term interbank credit--by changing the rate of interest the Fed pays on reserve balances that banks hold at the Fed.
A bank is unlikely to lend to another bank or to any of its customers at an interest rate lower than the rate that the bank can earn on reserve balances held at the Fed. And because overall reserve balances are currently abundant, if a bank wants to borrow reserve balances, it likely will be able to do so without having to pay a rate much above the rate of interest paid by the Fed.
How changes in the federal funds rate affect the broader economy Changes in the FOMC's target for the federal funds rate affect overall financial conditions through several channels. For instance, federal funds rate changes are rapidly reflected in the interest rates that banks and other lenders charge on short-term loans to one another, households, nonfinancial businesses, and government entities. In particular, the rates of return on commercial paper and U.
Treasury bills--which are short-term debt securities issued by private companies and the federal government, respectively, to raise funds--typically move closely with the federal funds rate. Similarly, changes in the federal funds rate are rapidly reflected in the rates applied to floating-rate loans, including floating-rate mortgages as well as many personal and commercial credit lines. Longer-term interest rates are especially important for economic activity and job creation because many key economic decisions--such as consumers' purchases of houses, cars, and other big-ticket items or businesses' investments in structures, machinery, and equipment--involve long planning horizons.
The rates charged on longer-term loans are related to expectations of how monetary policy and the broader economy will evolve over the duration of the loans, not just to the current level of the federal funds rate. For this reason, revisions to the expectations of households and businesses regarding the likely course of short-term interest rates can affect the level of longer-term interest rates. Fed communications about the likely course of short-term interest rates and the associated economic outlook, as well as changes in the FOMC's current target for the federal funds rate, can help guide those expectations, resulting in an easing or a tightening of financial conditions.
In addition to eliciting changes in market interest rates, realized and expected changes in the target for the federal funds rate can have repercussions for asset prices. Changes in interest rates tend to affect stock prices by changing the relative attractiveness of equity as an investment and as a way of holding wealth. Fluctuations in interest rates and stock prices also have implications for household and corporate balance sheets, which can, in turn, affect the terms on which households and businesses can borrow.
Variations in interest rates in the United States also have a bearing on the attractiveness of U. Changes in interest rates, stock prices, household wealth, the terms of credit, and the foreign exchange value of the dollar will, over time, have implications for a wide range of spending decisions made by households and businesses. For example, when the FOMC eases monetary policy that is, reduces its target for the federal funds rate , the resulting lower interest rates on consumer loans elicit greater spending on goods and services, particularly on durable goods such as electronics, appliances, and automobiles.
Lower mortgage rates make buying a house more affordable and encourage existing homeowners to refinance their mortgages to free up some cash for other purchases. Lower interest rates can make holding equities more attractive, which raises stock prices and adds to wealth. Higher wealth tends to spur more spending. Investment projects that businesses previously believed would be marginally unprofitable become attractive because of reduced financing costs, particularly if businesses expect their sales to rise.
And to the extent that an easing of monetary policy is accompanied by a fall in the exchange value of the dollar, the prices of U. Even after this large cut, the U. However, with the federal funds rate near zero, the Fed could no longer rely on its primary means of easing monetary policy. One of the ways in which the FOMC provided further support to the economy was by offering explicit forward guidance about expected future monetary policy in its communications.
The FOMC conveyed that it likely would keep a highly accommodative stance of monetary policy until a marked improvement in the labor market had been achieved. Short-term interest rates expected to prevail in the future and longer-term yields on bonds fell in response to this forward guidance. By boosting the overall demand for these securities, the Fed put additional downward pressure on longer-term interest rates.
In addition, it leads people to spend time and resources hedging against inflation instead of pursuing more productive activities. Another problem is that a surprise inflation tends to redistribute wealth. For example, when loans have fixed rates, a surprise inflation redistributes wealth from lenders to borrowers, because inflation lowers the real burden of making a stream of payments whose nominal value is fixed.
For example, if inflation is very low or close to zero, then short-term interest rates also are likely to be very close to zero. In that case, the Fed might not have enough room to lower short-term interest rates if it needed to stimulate the economy. Rather, in a deflation, prices are falling throughout the economy, so the inflation rate is negative. But, in fact, deflation can be as bad as too much inflation.
And the reasons are pretty similar. For example, to go back to the case of the fixed-rate loan, a surprise deflation also redistributes wealth, but in the opposite direction from inflation, that is, from borrowers to lenders. The reason is that deflation raises the real burden of making a stream of payments whose nominal value is fixed.
A substantial, prolonged deflation, like the one during the Great Depression, can be associated with severe problems in the financial system. It can lead to significant declines in the value of collateral owned by households and firms, making it more difficult to borrow. And falling collateral values may force lenders to call in outstanding loans, which would force firms to cut back their scale of operations and force households to cut back consumption.
Moreover, this is all the Fed can achieve in the long run. But the Fed, of course, also can affect output and employment in the short run. And big swings in output and employment are costly to people, too. So, in practice, the Fed, like most central banks, cares about both inflation and measures of the short-run performance of the economy.
Yes, sometimes they are. One kind of conflict involves deciding which goal should take precedence at any point in time. Another kind of conflict involves the potential for pressure from the political arena. For example, in the day-to-day course of governing the country and making economic policy, politicians may be tempted to put the emphasis on short-run results rather than on the longer-run health of the economy.
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