Overview of Recent Changes to Federal Reserve Monetary Policy
Note to students: In recent years there have been some very significant changes to the way in which the Fed
approaches monetary policy. A summary of those changes is presented below. As you'll see, our text needs some
updating.
The 2008 Financial Crisis, COVID-19, and a realization on the part of the Fed that they have a responsibility to
address not just average unemployment but also the much higher unemployment rates for minorities have all
contributed to these changes.
Please see the following links for further reading:
https://www.stlouisfed.org/on-the-economy/2020/october/key-elements-fed-monetary-policy-strategy
https://www.bloomberg.com/news/articles/2021-06-26/why-the-fed-has-a-new-framework-and-why-it-mattersquicktake (this last link is only available if you have a Bloomberg News subscription)
The main objectives of the Fed are to promote price stability (i.e., control inflation) and full
employment. The Fed uses contractionary and expansionary policy to achieve these two
objectives.
Contractionary policy aims at raising interest rates which helps put the brakes on inflation and
an overheated economy. This has the downside of risking putting the economy into recession
and increasing unemployment.
Expansionary policy aims at keeping interest rates low which should reduce unemployment but
risks promoting inflation.
In recent years the Fed has made some significant changes in the way it pursues its
contractionary and expansionary policies. In the past, changes to the Fed Funds Rate and bank
reserve requirements along with the actions of the Federal Open Market Committee (FOMC)
were the Fed’s main tools to achieve their set targets for inflation and unemployment.
A lot of that has now change. To begin as of March 2020 the Fed reduced reserve requirements
to zero (link). The reason is that since the Financial Crisis in 2008 the Fed has been paying banks
to hold money in reserve and as a result reserve balances at the Fed are already
enormous. This, in turn, has fundamentally changed how the Fed conducts monetary policy.
In brief:
1) The Fed now in effect sets short term rates through the rate they pay banks on excess
reserves (i.e., all reserves at this point). This is called the Interest on Excess Reserves (IOER)
rate.
2) The Fed no longer uses Open Market Operations to influence interest rates because their
balance sheet is so large (because of 1 above) that open market operations would be too small
to have any effect on rates. Paying banks to hold money in reserve is a much more direct way
to influence interest rates. The IOER in effect sets a floor on interest rates since banks are
unlikely to want to lend at a rate lower than what they can earn by holding money at the Fed.
Here's a good link explaining the new system. https://www.frbsf.org/economicresearch/publications/economic-letter/2019/june/why-is-fed-balance-sheet-still-so-big/
Note also that in August 2020 the Fed changed how it sets policy targets for inflation and
unemployment. Prior to this change the Fed was pursuing a target rate of 2% for inflation and
roughly 4% for unemployment.
In brief:
1) The Fed is now pursuing an “average 2% rate” for inflation which means they will allow
inflation to overshoot their target of 2% in times of recovery, and
2) Rather than settling for their previous target of average full employment for the whole
economy they will allow average unemployment to continue to fall so long as inflation
remains low. This is intended to redefine full employment as a “broad based and inclusive
goal” that includes the generally much higher unemployment rates for Blacks and Hispanics.
The new policy seeks to use monetary policy to directly address these inequalities.
Here’s a good link summarizing these changes (this link is unfortunately only available if you
have a Bloomberg News subscription): https://www.bloomberg.com/news/articles/2021-0626/why-the-fed-has-a-new-framework-and-why-it-matters-quicktake