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Monetary Policy and the Federal Reserve: Current Policy and Conditions - CRS REPORT - AUGUST 2012

Monetary Policy and the Federal Reserve: Current Policy and Conditions - CRS REPORT - AUGUST 2012

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CRS Report for Congress
 Prepared for Members and Committees of Congress
Monetary Policy and the Federal Reserve:Current Policy and Conditions
Marc Labonte
Specialist in Macroeconomic PolicyAugust 3, 2012
Congressional Research Service
7-5700www.crs.govRL30354
 
 Monetary Policy and the Federal Reserve: Current Policy and ConditionsCongressional Research Service
Summary
The Federal Reserve (Fed) defines monetary policy as the actions it undertakes to influence theavailability and cost of money and credit. Because the expectations of market participants play animportant role in determining prices and growth, monetary policy can also be defined to includethe directives, policies, statements, and actions of the Fed that influence how the future is perceived. In addition, the Fed acts as a “lender of last resort” to the nation’s financial system,meaning that it ensures continued smooth functioning of financial intermediation by providingfinancial markets with adequate liquidity. This role has become of great importance following theonset of the recent financial crisis.Traditionally, the Fed has three means for achieving its goals: open market operations involvingthe purchase and sale of U.S. Treasury securities, the discount rate charged to banks who borrowfrom the Fed, and reserve requirements that governed vault cash or deposits with the Fed as a proportion of deposits. Historically, open market operations have been the primary means for executing monetary policy. Recently, in response to the financial crisis, direct lending becameimportant once again and the Fed has created a number of new ways for injecting reserves, credit,and liquidity into the banking system, as well as making loans to firms that are not banks. Asfinancial conditions normalized, direct lending tapered off. Emergency lending programs have been wound down, with the exception of foreign central bank liquidity swaps.The Fed traditionally conducts open market operations by setting an interest rate target that it believes will allow it to achieve price stability and maximum sustainable employment. Theinterest rate targeted is the federal funds rate, the price at which banks buy and sell reserves on anovernight basis. This rate is linked to other short-term rates and these, along with inflationexpectations, influence longer-term interest rates. Interest rates affect interest-sensitive spendingsuch as business capital spending on plant and equipment, household spending on consumer durables, and residential investment. Through this channel, monetary policy can be used tostimulate or slow aggregate spending in the short run. In the long run, monetary policy mainlyaffects inflation. A low and stable rate of inflation promotes price transparency and, thereby,sounder economic decisions by households and businesses.Beginning in September 2007, in a series of 10 moves, the federal funds target was reduced from5.25% to a range of 0% to 0.25% on December 16, 2008, where it now remains. Since then, theFed has added liquidity to the financial system beyond what is needed to meet its federal fundstarget through direct lending and, more recently, purchases of Treasury and government-sponsored enterprise (GSE) securities. This practice is sometimes referred to as quantitativeeasing, which has tripled the size of the Fed’s balance sheet since financial turmoil began. Sincequantitative easing has ended, the Fed has bought long-term Treasury securities and sold an equalamount of short-term securities through the Maturity Extension Program, popularly known as“Operation Twist.”Congress has delegated responsibility for monetary policy to the Fed, but retains oversightresponsibilities to ensure that the Fed is adhering to its statutory mandate “maximumemployment, stable prices, and moderate long-term interest rates.” H.R. 245 would switch to asingle mandate of price stability. The Dodd-Frank Act enhanced the GAO’s ability to audit theFed, and required a review of its emergency programs. H.R. 459, which the House passed on July25, 2012, would remove all remaining restrictions on GAO’s audit powers. H.R. 245, S. 3219,H.R. 1512, and H.R. 3428 would change the Fed’s governance structure.
 
 Monetary Policy and the Federal Reserve: Current Policy and ConditionsCongressional Research Service
Contents
Introduction......................................................................................................................................1
 
How Does the Federal Reserve Execute Monetary Policy?............................................................2
 
Economic Effects of Monetary Policy in the Short Run and Long Run....................................5
 
Monetary vs. Fiscal Policy........................................................................................................6
 
The Recent and Current Stance of Monetary Policy........................................................................8
 
Before the Financial Crisis........................................................................................................9
 
During and After the Financial Crisis........................................................................................9
 
The Growth in the Balance Sheet and Bank Reserves......................................................11
 
Central Bank Liquidity Swaps..........................................................................................12
 
Maturity Extension Program or “Operation Twist”...........................................................14
 
Congressional Oversight and Disclosure.......................................................................................14
 
The Federal Reserve’s Mandate and Its Independence..................................................................15
 
Contacts
Author Contact Information...........................................................................................................17
 
Acknowledgments.........................................................................................................................17
 

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