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Federal Reserve’s Monetary Policy

Established in 1913, the Federal Reserve, America’s central banking system, plays an
important role in the U.S economy through its control of the country’s monetary policy (Hubbard
& O’Brien, 2017). At the helm of the Federal Reserve System is Federal Reserve Board headed
by a chairman. Each half year, the Federal Reserve’s chair presents to Congress the board’s
monetary policy report for the previous half year. The report contains economic and monetary
components and presents the Federal Reserve rationale for its most recent monetary policy
moves. Here is a look at the board’s most recent policy actions as presented in its July 2018
report to Congress by its chairman.

In the report, the Federal Board maintained recent increases in federal funds rate. The rate
was raised to the range of 1.75% – 2 (Federal Reserve, 2018). According to the chair, this range
was the most appropriate in achieving the Federal Reserve’s two main goals of keeping inflation
below 2% and supporting maximum employment. At the time of the policy announcement,
unemployment was 4% (Federal Reserve, 2018).
This monetary policy reflects the Federal Reserve’s belief that the economy is doing well.
Economic growth has remained strong with an average annual growth of 2% (Federal Reserve,
2018). This growth has largely been due to increasing consumer confidence, more disposable
income resulting from tax cuts, and strong jobs growth (Federal Reserve, 2018). In the first six
months of 2018, an average of 215,000 jobs were created every month (Federal Reserve, 2018).
Importantly, this strong economic activity has not led to corresponding fast increase in inflation.
Core inflation (excluding energy and food items) has been at 2%. When energy and food items
are added inflation rises to more than 2%. However, the two items fluctuate so much that their

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inclusion does not present a realistic inflation level in the general economy. The core inflation
rate is within the Federal Reserve’s goal of having inflation that is less than 2% (Federal Reserve,
2018).
The current monetary policy of the Federal Reserve is contractionary in nature. By
raising federal fund rate the Federal Reserve hopes to reduce the level of liquidity in the market
and, therefore, reduce inflation level as well (Hubbard & O’Brien, 2017). The policy is taken
when there is strong economic growth. Since such growth often leads to rising inflation,
contractionary policy interventions are aimed at preventing rise of inflation which may neutralize
the benefits of the economic growth.
I believe that this Federal Reserve’s policy of gradually increasing federal funds rate is
the appropriate one. With recent strong economic growth which has led to falling
unemployment, there is risk that inflation may quickly go over the 2% target. Thus, by gradually
increasing the fed fund’s rate, the Federal Reserve Board ensures that the economy does not grow
so much to cause extremely high inflation which may be hard to control in the long run.
However, I feel that the board’s federal fund rate’s increase has been done too fast. Even though
unemployment is falling, there is still room for more falls. Additionally, the wages are still, on
average, relatively low. By quickly increasing the federal funds rate, the Federal Reserve Board
hurts workers by keeping wages low. I would suggest that as long as inflation remains below 2%
the Federal Reserve should let the economic growth to continue and allow not just employment
to fall but also wages to increase. Thus, instead of raising federal funds rate almost four times a
year, it should raise the rate just once a year by a quarter a percentage.

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These interventions into the economy by the Federal Reserve have generated significant
debate with some arguing that they are unhelpful. Personally, I believe that the Federal Reserve
should intervene in the economy when it is not functioning well. An economy that is not
functioning well is characterized by high inflation, high unemployment, and general low
economic activity (Gali, 2015). It could also be characterised by extremely high economic
growth that is unsustainable and deflation.
Regardless of how a poorly functioning economy manifests itself, the intervention of the
Federal Reserve has in most cases had a positive effect. Apart from the Great Depression of the
1930s, the Federal Reserve ‘s intervention in the economy when it was not functioning well has
prevented slow economic growth from turning into a recession and recessions from becoming
depressions (Broten & Collins, 2017). A good example is the 2007-2008 financial crisis and the
ensuing Great Recession. It is clear that without the Federal Reserve’s vigorous intervention, the
recession would have turned into a depression. Some of the drastic steps that the Federal Reserve
took include keeping federal funds rates at near 0%, orchestrating the bailing out of some very
important financial institutions, and buying bonds worth close to $3 trillion which greatly
increased supply of money in the economy (Broten & Collins, 2017).
It could be argued that some of these actions, such as orchestrating of bail out of some
banks, created moral hazard. Financial institutions may be more willing in future to make risky
decisions because they know the Federal Reserve will bail them out when things go bad.
Additionally, the massive increase in supply of money in the economy has led to significant
devaluation of the U.S. dollar (Gali, 2015). However, on the whole it is clear that the measures
taken by the Federal Reserve have had a largely beneficial role in the economy.

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The Federal Reserve’s monetary policies affect every section of the economy including
financial markets and other financial institutions. Generally, a raise in federal funds rate should
have a negative effect on the financial markets. This is because such a rise reduces liquidity in
the markets. In the recent past the Federal Reserve has been increasing the federal funds rate by a
quarter a percentage by as many as three times a year. Ordinarily, such a rise would have led to
underperformance of the financial markets. However, given that the Federal Reserve pumped
over $3 trillion in the economy during the Great Recession and maintained close to 0% federal
funds rate, the board’s monetary policy remains relatively accommodative (Broten & Collins,
2017). The loose money policy has allowed financial markets to continue performing strongly
even when the Federal Reserve has continued with its gradual increase in federal funds rate. The
Dow Jones Industrial Average and S&P reached their highs in over a decade in 2018 despite
increases in federal funds rates. For instance, Dow Jones’ 26,400 points in early 2018 was the
highest the stock market index has been in many years.

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References

Broten, N., & Collins, J. (2017). The Role of Monetary Policy. Macat Library.

Galí, J. (2015). Monetary policy, inflation, and the business cycle: an introduction to the new
Keynesian framework and its applications. Princeton University Press.

Federal Reserve (2018). Monetary Policy Report.
https://www.federalreserve.gov/monetarypolicy/2018-07-mpr-summary.htm

Hubbard, R. G., & O’Brien, A. P. (2017). Money, banking, and the financial system. Boston:
Pearson.