What are Federal Reserve Policies?
The American central banking system is called the Federal Reserve System, commonly known as the Federal Reserve or the Fed. Most people call it ‘the Fed.’ Policymakers, economists, and the media use this shorthand because it is concise and easily recognizable.
Personally, I prefer to use ‘the Fed’ in conversation and ‘the Federal Reserve’ in writing. However, as you will see in this article, I do sometimes use ‘the Fed’ in writing, but not as often as ‘the Federal Reserve.’ Which terms you choose to use is entirely up to you. There’s no strict rule requiring one over the other in general use.
The Federal Reserve was Born in 1913
The US Congress founded the Federal Reserve in 1913 to provide the country with a safer, more stable, and more flexible monetary and financial system.
The policymakers who created the Federal Reserve Act rejected the concept of a single central bank, like the ones in the UK and other countries. Instead, they provided for a central banking system which had a central governing board, 12 Reserve Banks as part of a decentralized structure, and a combination of public and private characteristics.
The Federal Reserve says the following about the American central banking system:
“The Federal Reserve is the U.S. central bank, created by the Federal Reserve Act of 1913 to establish a monetary system that could respond effectively to stresses in the banking system. The Federal Reserve System includes The Board of Governors, a federal agency located in Washington, D.C., and 12 Federal Reserve Banks around the nation.”
Introduction to the Federal Reserve Policies
The Federal Reserve policies aim to promote maximum employment, stabilize prices, and moderate long-term interest rates. It has at its disposal several tools, such as interest rates, open market operations, and reserve requirements. It manages economic growth, controls inflation, and maintains financial stability to support the country’s health and resilience.
The Fed manages economic growth, controls inflation, and maintains financial stability to support the U.S. economy’s health and resilience. Its actions impact borrowing, spending, and investment, affecting individuals, businesses, and the overall economy.
Later in the article, we shall look at the Federal Reserve policies in more detail.
Key Objectives of Federal Reserve Policies
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Price Stability
The Fed works to keep prices stable. It does this by managing inflation and preventing deflation.
When inflation is too high, everything, including goods and services, becomes more expensive. When deflation occurs, prices drop, which can slow down the economy.
By controlling inflation, the Fed helps keep prices steady and predictable. Price stability is good for the economy because it helps businesses, consumers, and investors plan and make decisions with more confidence.
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Maximum Employment
Keeping the unemployment rate low and stable is one of the Federal Reserve’s key goals. It does this by trying to create conditions that encourage businesses to hire more workers.
When more people have jobs, there is more money to spend, which strengthens the economy.
The Fed’s policies aim to create a job market where everyone who wants to work has opportunities.
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Moderate Long-Term Interest Rates
The Fed, like all other central banks across the world, aims for interest rates that support sustainable economic growth over time.
When the Fed adjusts interest rates, borrowing money gets easier or harder for consumers and businesses. Raising rates makes borrowing more expensive, while cutting them makes borrowing cheaper.
Keeping interest rates balanced or moderate over the long term helps ensure steady growth without overheating the economy.
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Financial Stability
The Fed works to ensure the stability of the financial system, including banks and other financial institutions.
Financial stability means a secure financial system where banks and other institutions operate smoothly, allowing individuals and businesses to access credit and manage their finances without disruptions. We are more likely to plan for the future when the financial system is stable.
When banks are safe and reliable, we can trust that our money is secure and that credit will be available when we need it. The Fed uses various tools to prevent financial crises that could harm the economy.
Primary Tools of Federal Reserve Policy
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Interest Rate Policy (Federal Funds Rate)
The federal funds rate is the main rate that the Fed controls. It affects other interest rates like loans and mortgages.
When the Fed raises the federal funds rate, borrowing becomes more expensive, slowing the economy. When they cut the rate, borrowing gets cheaper, encouraging spending and boosting the economy.
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Open Market Operations
When the Federal Reserve wants to adjust liquidity in the banking system, it may buy and sell US Treasury securities. We call this process ‘open market operations.’
These securities are also available for purchase by private individuals like you and me, large organizations, such as pension funds and insurance companies, and even foreign governments.
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Discount Rate and Discount Window Lending
The discount rate is the interest rate the Fed charges banks for short-term loans.
The discount window lets banks borrow from the Fed directly, helping them meet cash needs and support financial stability, especially in times of stress.
The discount rate is called the ‘Bank Rate’ in the UK and Ireland, the ‘Overnight Rate’ in Canada, the ‘Cash Rate’ in Australia, the ‘Repo Rate’ in India, and the ‘Official Cash Rate’ in New Zealand.
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Reserve Requirements
By law, banks must hold a minimum amount of cash in reserve. We call this the ‘reserve requirement.’ The Federal Reserve determines what the reserve requirements are.
Higher reserve requirements mean banks lend less, which slows the economy. Lower requirements, on the other hand, increase lending capacity, which stimulates economic activity.
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Quantitative Easing (QE) and Tightening (QT)
The Fed may buy assets, like government bonds, to increase the money supply, lower interest rates, and encourage spending. We refer to this measure as ‘quantitative easing’ or ‘QE.’
Sometimes the Fed does the opposite – it sells assets to reduce money in the economy, raise rates, and control inflation. We call this measure ‘quantitative tightening’ or ‘QT.’
How Federal Reserve Policies Affect the Economy
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Interest Rates and Consumer Spending
When the Fed raises interest rates, consumers spend less for two main reasons. 1. Their monthly payments on existing loans become more expensive, so they have less spare money. 2. Loans become more expensive, so people borrow less. Less borrowing leads to lower spending.
Conversely, when the Fed lowers rates, borrowing becomes more affordable, which can encourage people to spend more, boosting economic activity.
Put simply, when interest rates rise, consumers spend less, and when they fall, consumers spend more.
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Business Investment and Borrowing Costs
Interest rates have a similar effect on companies. When rates rise, companies borrow less. Since many investment plans involve borrowing, higher interest rates lead to less business investment.
Lower rates, however, result in more borrowing, which leads to greater spending and investment projects.
For example, you are more likely to apply for a loan to expand your factory if interest rates are low than if they are high.
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Employment and Wages
When the Fed lowers interest rates, businesses borrow more, which, as I mentioned above, leads to more spending and investment. This boosts the economy, potentially creating more jobs.
If demand for workers rises, employers may have to offer higher salaries to compete for employees.
If the Fed raises interest rates, on the other hand, hiring may slow, and wage growth could become less pronounced.
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Inflation Control
Central banks adjust interest rates to control inflation.
If inflation is rising too fast, the Federal Reserve may raise interest rates, which reduces spending, cools the economy, and tends to bring down inflation.
If inflation is too low, especially if the economy is slowing down—perhaps even entering a recession—the Fed may lower rates to boost spending, kickstart the economy, and prevent deflation.
Role of Federal Reserve Policies in Crisis Management
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Great Depression (1930s)
Initially, the Fed struggled to respond effectively, which exacerbated the economic depression.
Later, it began cutting interest rates and purchasing government bonds to increase money in the economy.
These actions eventually helped the economy recover, though it took several years to start having a positive effect.
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1970s Stagflation
In the 1970s, much of the world, including the US, faced “stagflation”—high inflation with stagnant economic growth.
The Federal Reserve raised interest rates sharply to control inflation, which led to a severe recession.
While painful, this strategy helped bring inflation down. This example shows that the Fed is committed to price stability, even if there is a short-term economic cost.
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1987 Stock Market Crash (“Black Monday”)
On Monday, October 19th, 1987, the Dow Jones Industrial Average (DJIA) fell 22.6% (508 points) in a single day. It still is the DJIA’s largest one day decline ever. Other major stock markets across the world experienced similar declines. Most current journalists and economists refer to that day as ‘Black Monday.’
The Fed responded quickly by cutting interest rates, providing emergency loans to banks, encouraging banks to lend, and issuing public statements of support.
This decisive action helped restore confidence, stabilize the markets, and prevent a more severe economic downturn.
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Financial Crisis of 2008
During the 2008 Financial Crisis and the Great Recession that followed, the Fed reduced interest rates and implemented Quantitative Easing (QE).
QE involved purchasing long-term securities to increase the money supply and keep interest rates low.
These measures lowered borrowing costs, pushed up asset prices, and influenced economic policies in the years that followed.
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COVID-19 Pandemic Response
When the COVID-19 pandemic hit in March 2020, the Federal Reserve responded quickly by cutting rates and creating lending programs to support businesses and keep the economy stable.
These actions helped prevent a deeper recession, though the increased liquidity contributed to later inflation. The Fed’s response highlighted both the benefits and challenges of emergency policies.
Federal Reserve and Monetary Policy in a Global Context
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Impact on Global Markets
The US economy is the largest in the world, so changes have far-reaching effects.
When the Fed raises interest rates, the value of the dollar tends to rise, making it more valuable against the euro, pound sterling, yen, and other currencies.
A stronger dollar makes US exports more expensive for other countries and imports cheaper for Americans.
Higher US interest rates also attract investors from overseas looking for better returns. This leads to capital (money) flowing into the US and away from other countries, which can affect their economies.
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Coordination with Other Central Banks
The Federal Reserve regularly works with other central banks, such as the European Central Bank, the Bank of England, and the Bank of Japan, to address global economic challenges.
For example, during financial crises, central banks may coordinate to lower interest rates together or to ensure there is enough liquidity in international markets.
This collaboration helps stabilize the global economy and prevent localized financial problems from spreading into other countries.
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Influence on Emerging Markets
Emerging economies are more vulnerable to changes in global financial conditions than advanced economies such as the U.S., UK, Western Europe, Canada, Japan, and Australia.
As mentioned earlier, when interest rates are raised in the US, investors might pull money out of emerging markets to invest there, leading to capital outflows.
Capital outflows can weaken emerging economies’ currencies, making it more expensive for them to pay back debt or import goods.
Conversely, when the Fed lowers rates, emerging markets typically experience capital inflows, which can strengthen their currencies and support economic growth.
Federal Reserve Policies and Public Perception
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Political Independence of the Fed
The Federal Reserve is independent from political influence. The US President, Congress, and Senate cannot tell the Fed what measures to take or not take. It is a politically independent entity.
Being free of outside influences or pressure is essential for making decisions that focus on long-term economic stability.
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Transparency and Communication with the Public
Transparency is key to building public trust in a country’s central banking system.
Through press releases, meeting minutes, testimonies before Congress, research reports, official statements, and speeches, the Fed keeps the public informed about its actions.
For example, when the Fed’s Federal Open Market Committee (FOMC) makes a decision on raising or cutting interest rates, it provides details on how many members voted for or against the decision, and who they were.
Criticisms and Challenges Facing Federal Reserve Policies
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Risks of Keeping Interest Rates Too Low
If the Fed keeps interest rates too low for too long, it can lead to asset bubbles. It can also encourage excessive risk-taking.
If asset prices shoot up and then come tumbling down, it can hurt the economy.
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Debate Over Quantitative Easing’s Long-Term Effects
Quantitative Easing boosts the economy, but it has downsides. It can increase wealth inequality by raising asset prices and may lead to inflation if too much money is added to the economy.
“Unless other countries are also taking quantitative easing measures, quantitative easing can drastically reduce the value of a country’s national currency.”
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Balancing Inflation with Full Employment
The Fed is tasked with controlling inflation and promoting employment. This can be a challenging mandate because measures to achieve one goal often have a negative effect on the other.
Policies that reduce inflation can slow job growth, while efforts to boost employment can increase inflation.
The Federal Reserve needs to strike the right balance.
Future Directions for Federal Reserve Policies
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Adapting to a Changing Economy
The world’s economies are evolving at a much faster pace today than ever before. As the US economy evolves, the Federal Reserve is constantly exploring new tools and approaches to keep up.
One area under consideration is digital currency policies. With the rise of digital and cryptocurrencies, the Fed is evaluating how a central bank digital currency (CBDC) could impact the economy and improve financial transactions.
Adapting to these changes may shape the future of US monetary policy. Given that cryptocurrencies have no central authority – no central bank – one wonders what will happen in the future if they dominate the economy.
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Addressing Climate-Related Financial Risks
Climate change could eventually undermine economic stability. The Federal Reserve is aware of this threat and has begun exploring ways to manage it.
By studying how extreme weather events and environmental policies affect businesses and banks, the Fed aims to ensure financial stability in a world facing climate challenges.
Most likely, future policies of the world’s central banks, including the Fed, will consider both environmental and financial impacts.
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Prospects for Continued Low Interest Rates
Since the Financial Crisis of 2008, interest rates have remained stubbornly low. There are questions about the long-term effects if this trend persists.
Prolonged low-interest rates can make borrowing cheaper, but they may also lead to increased debt and asset bubbles.
The Federal Reserve is currently analyzing how an extended period of low interest rates could impact economic growth, inflation, and financial stability in the future.
Final Thoughts
Let’s recap. The Federal Reserve plays a key role in the US economy by managing inflation, supporting employment, and promoting stable financial markets.
It does this by adjusting interest rates, providing loans to banks, and using strategies like quantitative easing or tightening to boost or slow down the economy during crises.
The Federal Reserve’s policies affect not only the domestic economy but also those of other countries. It can influence currencies, investment flows, and even emerging economies.
As the world changes, the Fed is exploring new approaches, like digital currencies and climate risk management, while also facing challenges like balancing inflation with employment goals.
By adapting and coordinating with other central banks, the Fed aims to support a stable and prosperous U.S. economy and contribute to global economic stability in the future.