Monetary Policy and the Federal Reserve: Current Policy and Conditions

Prepared for Members and Committees of Congress

The Federal Reserve defines monetary policy as the actions it undertakes to influence the
availability and cost of money and credit to help promote a stable price level and maximum
sustainable economic growth. Since the expectations of market participants play an important role
in determining prices and growth, monetary policy can also be defined to include the directives,
policies, statements, and actions of the Federal Reserve that influence how the future is perceived.
In addition, the Federal Reserve acts as a “lender of last resort” to the nation’s financial system,
meaning that it ensures its sustainability, solvency, and integrity. This role has become of great
importance with the onset of the financial crisis in the summer of 2007.
Traditionally, the Federal Reserve has had three means for achieving its congressionally
mandated goals: open market operations involving the purchase and sale of U.S. Treasury
securities, the discount rate charged to banks who borrow from it, and reserve requirements that
governed the proportion of deposits that must be held either as vault cash or as a deposit at the
Federal Reserve. Historically, open market operations have been the primary means for executing
monetary policy. Recently, in response to the financial crisis, the discount window has become
important once again and the Fed has created a number of new ways for injecting reserves, credit,
and liquidity into the financial systems as well making loans to non-financial firms. The scope
and magnitude of these changes are evolving.
The Federal Reserve conducts open market operations by setting an interest rate target that it
believes will allow it to achieve price stability and maximum sustainable growth. The interest rate
targeted is the federal funds rate, the price at which banks buy and sell reserves on an overnight
basis. This rate is linked to other short term rates and these, in turn, are linked to longer term
interest rates.
While monetary policy is charged with promoting maximum sustainable economic growth, it
does so only indirectly by maintaining a stable price level since the direct effect of monetary
policy is primarily on the rate of inflation. A low and stable rate of inflation through the business
cycle promotes price transparency and, thereby, sounder economic decisions by households and
The Fed has frequently changed the federal funds target to match changes in expected economic
conditions. Between January 3, 2001, and June 25, 2003, the target rate was reduced to 1% from

6½%. This policy was reversed on June 30, 2004. In 17 equal increments ending on June 29,

2006, the target rate was raised to 5¼%. No additional changes were made until September 18,

2007, when, in a series of 10 moves, the target was reduced to a range of 0% to1/4% on
December 16, 2008. These reductions were designed to ease credit market conditions and
stimulate spending. This report will be updated periodically as new data become available.

Introduc tion ..................................................................................................................................... 1
How Does the Federal Reserve Execute Monetary Policy?............................................................2
The Importance of Monetary Policy................................................................................................4
Monetary vs. Fiscal Policy........................................................................................................5
Short Run vs. Longer Run.........................................................................................................5
The Recent and Current Stance of Monetary Policy.......................................................................6
Congressional Oversight and The Near-Term Goals of Monetary Policy......................................9
Figure 1. Yield on Selected Treasury Securities and Federal Funds...............................................4
Table 1. Recent Economic Performance..........................................................................................7
Table 2. Federal Reserve System Economic Projections.................................................................9
Appendix A. The Federal Reserve’s Mandate and Its Independence............................................10
Appendix B. Federal Reserve and the Discount Rate...................................................................12
Appendix C. Federal Reserve and the Monetary Aggregates........................................................13
Author Contact Information..........................................................................................................14
Acknowledgments ......................................................................................................................... 14

The Federal Reserve defines monetary policy as the actions it undertakes to influence the
availability and cost of money and credit to promote the goals mandated by Congress: a stable
price level and maximum sustainable economic growth. Since the expectations of households as
consumers and businesses as the purchasers of capital goods exert an important influence on the
major portion of spending in the United States, and these expectations are influenced in important
ways by the actions of the Federal Reserve, a broader definition of monetary policy would
include the directives, policies, statements, forecasts of the economy, and other actions by the
Federal Reserve, especially those made by or associated with the chairman of its Board of 1
Governors, the nation’s central banker.
In addition, monetary policy has traditionally assigned to a central bank the role of “lender of last
resort” to the nation’s financial system. This role means that the Federal Reserve is responsible
for ensuring the sustainability, solvency, and integrity of the nation’s financial system as a whole,
although this does not necessarily extend to each individual financial institution. Thus, in times of
financial stress or crisis, the Federal Reserve is responsible for supplying the ultimate means of
payment to financial institutions. Historically, this has been limited to the banking system.
Indeed, the impetus for the founding of the Federal Reserve was an outgrowth of the financial 2
panic of 1907. During its nearly 100 year history, the Federal Reserve has rarely been called
upon to perform this role. It is now widely regarded as having failed to perform it during the
collapse of the U.S. banking system in the contraction of 1929-1933. However, the on-going
financial crisis that began in the summer of 2007 with the bursting of the “housing price bubble,”
has placed this role front and center. The Federal Reserve has responded in the conventional way
by making massive additions of reserves available to depository institutions (primarily
commercial banks) through the purchase of U.S. Treasury securities and allowing banks to
discount large amounts of eligible paper. In addition, it has created a number of additional ways
to make credit available to a broader range of financial institutions as well as making loans
directly to non-financial firms. These innovations are still evolving and several appear to have a 3
limited life.
Thus, the Federal Reserve has two monetary policy functions. Its main function is one of demand
management. The availability and cost of credit are used to manage aggregate demand in such a
way as to promote a stable price level and through it maximum sustainable growth. Its second 4
function is as “lender of last resort” to the nation’s financial system.

1 For a discussion of the important role played by expectations in formulation and execution of monetary policy, see
Santomero, Anthony M. “Great Expectations: The Role of Beliefs in Economics and Monetary Policy. Business
Review, Federal Reserve Bank of Philadelphia. Second Quarter 2004, pp. 1-6, and Sellon, Gordon H., Jr., “Expectations
and the Monetary Policy Transmission Mechanism, Economic Review. Federal Reserve Bank of Kansas City, Fourth
Quarter 2004, pp. 4-42.
2 For a discussion of Federal Reserve independence and its Congressional mandate, see Appendix A.
3 For a discussion of the current financial crisis, its origins, and the innovations by the Federal Reserve, see CRS Report
RL34730, The Emergency Economic Stabilization Act and Current Financial Turmoil: Issues and Analysis, by Baird
Webel and Edward V. Murphyand CRS Report RL34427, Financial Turmoil: Federal Reserve Policy Responses, by
Marc Labonte. For historical perspective on Federal Reserves dealing in non-government debt, see Wheelock, David
C.Conducting Monetary Policy Without Government Debt: The Fed’s Early Years. Review, Federal Reserve Bank of
St. Louis. May/June 2002, pp. 1-14.
4 This report will deal with the traditional role of the Federal Reserve. Thelender of last resort” role is examined in
CRS Report RL34427, Financial Turmoil: Federal Reserve Policy Responses, by Marc Labonte, Op. Cit. by Marc

The Federal Reserve has traditionally relied on three means to conduct monetary policy and they
are used to alter the reserves available to depository institutions. These institutions are required to
maintain reserves in the form of vault cash (currency) or as a deposit at the Federal Reserve
against their deposit liabilities, primarily checking, saving, and time (CDs). The size of these
reserves places a ceiling on the amount of deposits that financial institutions can have outstanding
and deposit liabilities are related to the amount of assets these institutions can acquire. These
assets are often called “credit” since they represent loans made to businesses and households,
among others.
If the Federal Reserve wishes to expand money and credit, it has three ways to do so. The primary
method is called open market operations and it involves the Fed buying and selling seasoned U.S.
Treasury securities (or those that have been already issued and sold to private investors). Should
it buy securities, it does so with the equivalent of newly issued currency (Federal Reserve notes).
This expands the reserve base and the ability of depository institutions to make loans and expand
money and credit. The reverse is true if the Fed decides to sell securities from its portfolio. The
Fed can also change the reserve requirement meaning that a given amount of reserves will now
support more or less deposits and, in the process, this will affect the lending capability of
financial institutions (this is rarely used today). Finally, the Fed permits certain depository
institutions to borrow from it directly on a temporary basis. That is, these institutions can
“discount” at the Fed some of their own assets to provide a temporary means for obtaining
reserves. Discounts are usually on an overnight basis. For this privilege they are charged an
interest rate called, appropriately, the discount rate. Direct lending from the discount window and
other recently created lending facilities was negligible until late 2007, but has been an important 5
source of reserves since then.
Since the Federal Reserve defines monetary policy as the actions it undertakes to influence the
availability and cost of money and credit, this suggests two ways to measure the stance of
monetary policy. One is to look at the cost of money and credit as measured by the rate of interest
relative to inflation (or inflation projections), while the other is to look at the growth of money
and credit itself. Thus, one can look at either interest rates or the growth in the supply of money
and credit in coming to a conclusion about the current stance of monetary policy, that is, whether
it is expansionary, contractionary, or neutral.
Since the great inflation of the 1970s, most central banks have preferred to formulate monetary 6
policy more in terms of the cost of money and credit rather than on their supply. The Federal
Reserve thus conducts monetary policy by focusing on the cost of money and credit as proxied by
an interest rate. In particular, it targets a very short term interest rate known as the federal funds
rate. This rate is determined in the overnight market for reserves of depository institutions. At the

5 For a more complete discussion of the role of the discount rate in Federal Reserve policy, see Appendix B.
6 For a discussion of why the Federal Reserve does not conduct monetary policy by targeting the monetary aggregates,
see Appendix C.

end of a given period, usually a day, depository institutions must calculate how many dollars of 7
reserves they want to hold against their reservable liabilities (deposits). Some institutions may
discover a reserve shortage (too few reservable assets relative to those it wants to hold) while
others may have had reservable assets in excess of their wants. A market exists in which these
reserves can be bought and sold on an overnight basis. The interest rate in this market is called
the federal funds rate. It is this rate that the Federal Reserve uses as a target for conducting
monetary policy. If it wishes to expand money and credit, it will lower the target which
encourages more lending activity and, thus, demand in the economy. To support this lower target,
the Fed must stand ready to buy more U.S. Treasury securities. Conversely, if it wishes to tighten
money and credit, it will raise the target and remove as many reserves from depository
institutions as are necessary to accomplish its ends. This will require the sale of treasuries from its 8
portfolio of assets.
The federal funds rate is linked to the interest rates that banks and other financial institutions
charge for loans – or the provision of credit. Thus, while the Fed may directly influence only a
very short term interest rate, this rate is linked to other longer term rates. However, as shown on
Figure 1, this relationship is far from being on a one-to-one basis since the longer term market
rates are influenced not only by what the Fed is doing today, but what it is expected to do in the
future and what inflation is expected to be in the future. This highlights the importance of
expectations in explaining market interest rates. For that reason, there is a growing body of
literature that urges the Federal Reserve to be very transparent in explaining what its policy is and
will be and making a commitment to adhere to that policy. In fact, the Fed has responded to this
literature and is increasingly transparent in explaining its policies and what they are expected to

7 Depository institutions are obligated by law to hold some fraction of their deposit liabilities as reserves. In addition,
they are also likely to hold additional or excess reserves based on certain risk assessments they make about their
portfolios and liabilities. Until very recently these reserves were non-income earning assets. The Fed now pays interest
on both types of reserves. It is too early to assess how this shift in policy will affect bank reserve holdings.
8 For a technical discussion of how this is actually done, see Edwards. Cheryl L.Open Market Operations in the
1990s,” Federal Reserve Bulletin, November 1997, pp. 859-872.

Figure 1. Yield on Selected Treasury Securities and Federal Funds
0OO O1 O2 O3 O4 05 06 07 08
Three Month Federal Funds
Five YearLong Term
Source: Federal Reserve
Using market interest rates as an indicator of monetary policy is fraught with danger, however.
The interest rate that is essential to decisions made by households and businesses to buy capital
goods is what economists call the “real” interest rate. It is often proxied by subtracting from the
market interest rate the actual or expected rate of inflation. The real rate is largely independent of
the amount of money and credit since over the longer run, it is determined by the interaction of
saving and investment (or the demand for capital goods). The internationalization of capital
markets means that for most developed countries the relevant saving and investment that
determines the real interest rate is on a global basis. Thus, real rates in the United States depend
not only on our national saving and investment, but on the saving and investment of other
countries as well. For that reason national interest rates will be influenced by international credit
conditions and business cycles.

It has been said the “money matters” and the case for this statement can be made in at least two
different contexts. In one, monetary policy is compared with fiscal policy and, given the current
international financial system with flexible exchange rates and a high degree of capital mobility
between countries, the ability of changes in monetary policy to affect aggregate demand is great
compared with fiscal policy. In the other context, changes in monetary policy have the potential
to bring about major changes in the growth of GDP and employment only in the short run. Most
economists do not believe that this holds true over the longer run. Over the more extended
horizon, monetary policy has its primary effect on the rate of inflation. A brief discussion of the
two contexts summarized above follows.

The standard open economy macroeconomic model makes a compelling case for the relative
importance of monetary policy in a world whose financial arrangements involve the use of
flexible exchange rates and where capital is highly mobile between countries. To see this, fiscal
and monetary expansion will be contrasted.
Allow the full employment budget deficit to rise (or the full-employment surplus to fall) through
either a tax rate cut or a rise in appropriated expenditures. While the increase in this budget deficit
(or fall in surplus) raises aggregate demand, it also reduces national saving. The fall in the supply
of saving relative to domestic investment demand causes domestic interest rates (both real and
market) to rise relative to those in other financial centers. The rise in domestic interest rates
makes U.S. financial assets more attractive to foreigners. They, in turn, increase the demand for
dollars in foreign exchange markets to acquire the wherewithal to purchase U.S. assets. The
increased demand for dollars causes the dollar to appreciate. Dollar appreciation then reduces the
cost of foreign goods and services to Americans and raises the price of American goods and
services to foreigners. As a result, U.S. spending on imports tends to rise and foreign spending on
U.S. exports tends to fall. Thus, any expansionary effects on domestic demand from the larger
budget deficit tends to be offset in part or total by a reduced foreign trade surplus or a larger 9
foreign trade deficit.
Monetary policy stimulus (as shown by a reduction in the target rate for federal funds) initially
serves to lower U.S. interest rates (both real and market) relative to those in other financial
centers. Foreign financial assets become more attractive to U.S. investors, the supply of dollars on
the foreign exchange markets rises as U.S. investors attempt to acquire foreign currencies to buy
foreign assets, and the dollar depreciates. Dollar depreciation then makes foreign goods and
services more expensive to Americans and American goods and services cheaper to foreigners. As
a result, the United States spends less on imports and foreigners spend more on U.S. exports. A
falling foreign trade deficit or rising trade surplus thus reinforces any stimulus to domestic
demand that comes from lower U.S. interest rates.
The implication from the standard open economy macroeconomic model is that monetary policy
is more powerful than fiscal policy in influencing GDP growth and employment given current 10
international financial arrangements.
The analysis above suggests that a more expansive monetary policy can cause domestic demand
to expand. An examination of U.S. economic history will show that money and credit induced
demand expansions can have a positive effect on U.S. GDP growth and total employment. This
same history, however, also suggests that over the longer run, a more rapid rate of growth of

9 It is important to note that this explanation requires the full employment or structural budget deficit to rise. Budget
deficits produced by a fall in income, or cyclical deficits need not produce these results.
10It might be thought that this highly stylized account of monetary and fiscal policy is irrelevant to a world whose
financial institutions and practices are undergoing rapid change. For a contrary view, see Sellon, Gordon H., Jr.The
Changing U.S. Financial System: Some Implications for the Monetary Transmission Mechanism. Economic Review.
Federal Reserve Bank of Kansas City. First Quarter 2002, pp. 5-36.

money and credit is largely dissipated in a more rapid rate of inflation with little if any lasting
effect on real GDP and employment.
Economists have two explanations for this paradoxical behavior. First, they note that, in the short
run, many economies have an elaborate system of contracts (both implicit and explicit) that
makes it difficult in a short period for significant adjustments to take place in wages and prices in
response to a more rapid growth of money and credit. Second, they note that expectations for one
reason or another are slow to adjust to the longer run consequences of major changes in monetary
policy. This slow adjustment also adds rigidities to wages and prices. Because of these rigidities,
changes in the growth of money and credit that change aggregate demand can have a large initial
effect on output and employment. Over the longer run, as contracts are renegotiated and
expectations adjust, wages and prices rise in response to the change in demand and much of the
change in output and employment is undone. Thus, monetary policy can matter in the short run 11
but be fairly neutral for GDP growth and employment in the longer run.
It is noteworthy that in societies where high rates of inflation are endemic, the short run may be
very short indeed. During the final stages of very rapid inflations, called hyperinflation, the
ability of more rapid rates of growth of money and credit to alter GDP growth and employment is
virtually nonexistent, if not negative.

The behavior of three major indicators of economic performance are set out in Table 1. They
show an expansion that got underway beginning in December 2001. Initially the expansion in
demand was insufficiently robust to bring about a fall in the unemployment rate and it continued
to rise into mid-2003. As the expansion took hold, the unemployment rate began to fall, reaching

4.4% in October 2006. The inflation rate, with the exception of 2004, remained under 2%

throughout 2006. However, it began to accelerate in 2007. Initially, the acceleration was
attributed, correctly, to the increase in energy prices. These increases did not show up in price
indices (including, for example, the core Consumer Price Index) that excluded energy.
Nevertheless, as energy price increases accelerated, they became a matter of concern to the
Federal Reserve.

11Two interesting papers bearing on what monetary policy can accomplish by two former officials of the Federal
Reserve are Santomero, Anthony M. “What Monetary Policy Can and Cannot Do, Business Review, Federal Reserve
Bank of Philadelphia, First Quarter 2002, pp. 1-4, and Mishkin, Frederic S. “What Should Central Banks Do?, Review,
Federal Reserve Bank of St. Louis, November/December 2000, pp. 1-14.

Table 1. Recent Economic Performance
Year Real Growtha Inflation Rateb Unemployment Ratec
2000 2.3 2.3 4.0
2001 0.2 1.7 4.7
2002 1.9 1.9 5.8
2003 3.7 1.8 6.0
2004 3.0 3.1 5.5
2005 2.6 1.9 5.1
2006 2.4 1.9 4.6
2007:1Q 0.1 3.4 4.5
:2Q 4.8 3.6 4.5
:3Q 4.8 2.5 4.6
:4Q -0.2 4.3 4.8
2008:1Q 0.9 3.6 4.9
:2Q 2.8 4.3 5.3
:3Q -0.5 5.4 6.0
Source: U.S. Departments of Labor and Commerce.
a. Real growth and inflation are measured on a fourth quarter over fourth quarter basis. For 2007 and 2008,
the quarterly data are at annualized rates.
b. Inflation is measured by the price deflator for Personal Consumption Expenditures (PCE) on a fourth
quarter over fourth quarter basis. For 2007 and 2008, the quarterly data are at annualized rate.
c. Annual data are the average unemployment rate for the year. For 2007 and 2008, the quarterly data are the
average unemployment rate for three months of the quarter.
Price increases and the view that with the unemployment rate as low as 4.4%, the U.S. economy
was probably close to operating at its long run potential, led the Fed to initiate a gradual
tightening of monetary policy. The federal funds target was slowly ratcheted upward. In 17 steps,
it was raised in uniform increments to 5-1/4% on June 30, 2006 from 1% a year earlier. Short
term interest rates followed and by the end of 2006, the yield curve had become inverted, with 12
shorter term rates higher than longer term rates.
The shift in financing housing from fixed to variable rate mortgages made this sector of the
economy increasingly vulnerable to movements in short term interest rates. In particular, critics

12 Yield curve inversions pose potentially difficult problems for depository institutions since they squeeze their
profitability and possibly undermine their capital structure. The reason for this is that depository institutions generally
lend long and borrow short. Thus, their borrowing (their ability to attract and retain deposits which are the source of
their funds) costs are very sensitive to movements in short term interest rates. Since they lend long, only a fraction of
their assets, their new loans, are affected by movements in longer term rates. Thus, when short term rates rise relative to
long term rates, depository institutions find their costs rising sharply as they struggle to retain and attract deposits,
while the gross earnings from their assets rise only slowly the classic case of a profit squeeze. In fact, if losses ensue,
they undermine the capital base of these institutions setting in motion the possibility of failure. In any case, an inverted
yield curve generally has negative effects on credit creation and is often a leading indicator of an impending economic
downturn (see CRS Report RS22371, The Pattern of Interest Rates: Does It Signal an Impending Recession?, by Marc
Labonte and Gail E. Makinen.

now claim that the low short term rates prevailing from 2001 through 2004 caused an increased
demand for housing leading to a “price bubble.” An unintended consequence of the tightening of
monetary policy, critics now claim, was to burst this “price bubble” (a bubble that was also due,
in part, to lax lending standards). The net result was the on-set of a financial crisis affecting not
only depository institutions, but other segments of the financial sector involved with housing
finance as the delinquency rates on home mortgages rose to record numbers and the subsequent
losses of financial institutions made national headlines. The contagious nature of this
development was soon obvious as other types of loans and credit became adversely affected.
This, in turn, spilled over into the broader economy as the lack of credit soon had a negative
effect on both production and aggregate demand. During the fourth quarter of 2007, GDP
contracted at an annual rate of 0.2%. Initially, the unemployment rate stayed fairly steady and did
not show significant increases until mid-summer 2008. This was due in part to the fact that GDP
growth was again positive during the first two quarters of 2008 at annualized rates of 0.9% and
2.8%, respectively. However, during the third quarter GDP contracted once again at an annual
rate of 0.5%. The unemployment rate continued to rise, reaching 6.7% in November. Payroll
employment in November was nearly 1.75 million below the expansion peak reached in
December 2007.
The economic forecasts for 2009, including that by the Federal Reserve shown below, expect the
economy to continue to contract into mid-2009. The initial stages of recovery are expected to be
insufficiently strong to prevent the unemployment rate from rising. Currently, the unemployment 13
rate during the fourth quarter of 2009 is expected to be near 8%.
As the magnitude of the financial crisis as well as its international scope became apparent, the
Federal Reserve responded to the expected economic slump by reducing the federal funds target
and the discount rate. Beginning on September 18, 2007 and ending on December 16, 2008, the
target was reduced to a range of 0% to 1/4% from 5-1/4%. This entailed an unprecedented
increase in the reserves of depository institutions. They increased from about $44.6 billion in
August 2008 to nearly $644 billion during the first week of December (of these only about $54
billion were required). What began to concern the monetary authorities is that these large increase
in reserves were not being lent out. It would appear that the traditional transmission mechanism
for monetary policy is not working, if not broken down. To circumvent this problem, the Fed
began to employ a little used provision of the Federal Reserve Act that allows it to make loans to
other financial institutions and to non-financial firms as well. The magnitude of these loans has
been large. Total borrowing from the Federal Reserve during November 2007 was $366 million.
During the first week of December, 2008, it had grown to $676 billion (down from a high of $725
billion in mid-November). This is clearly not a “business as usual” monetary policy, but
something quite extraordinary. Once credit markets resume functioning smoothly, the task facing
the Federal Reserve will be to remove this huge amount of credit from the financial system
quickly enough to prevent inflation from taking hold.

13For a more extensive discussion of current economic conditions, see CRS Report RL30329, Current Economic
Conditions and Selected Forecasts, by Gail E. Makinen.

The primary form of congressional oversight of the Federal Reserve is the semi-annual hearings
with the Senate Committee on Banking, Housing, and Urban Affairs and the House Committee on
Financial Services. At these hearings, which take place in February and July, the Fed Chairman
presents the Fed’s Monetary Policy Report to the Congress, testifies, and responds to questions
from committee members. These hearings and reporting requirements were established by the
Full Employment Act of 1978 (P.L. 95-523, 92 Stat 1897), also known as the Humphrey-Hawkins
Act, and renewed in the American Homeownership and Economic Opportunity Act of 2000 (P.L.


The semiannual Monetary Policy Report presents a review of recent economic and monetary
policy developments, as well as economic projections for three years. Since monetary policy
plays an important role in determining economic outcomes, these projections can be viewed as
the Fed’s perceptions of how today’s monetary policy stance will influence future economic
conditions. To increase the transparency of monetary policy, the Fed in 2007 began to provide
additional forecasts. They now appear quarterly. The most recent, from the Minutes of the Federal
Open Market Committee of October 28-29, 2008, representing the views of the Board of
Governors and the 12 Reserve Bank Presidents, is presented in Table 2. These are contrasted with 14
the projections made for similar variables by the same group in April and June, 2008.
Table 2. Federal Reserve System Economic Projections
(Percent) 2008 2009 2010
Growth of real GDP 0.0 to 0.3 -0.2 to 1.1 2.3 to 3.2
June Projections 1.0 to 1.6 2.0 to 2.8 2.5 to 3.0
April Projections 0.3 to 1.2 2.0 to 2.8 2.6 to 3.1
Unemployment Rate 6.3 to 6.5 7.1 to 7.6 6.6 to 7.3
June Projections 5.5 to 5.7 5.3 to 5.8 5.0 to 5.6
April Projections 5.5 to 5.7 5.2 to 5.7 4.9 to 5.5
PCE Inflationa 2.8 to 3.1 1.3 to 2.0 1.4 to 1.8
June Projections 3.8 to 4.2 2.0 to 2.3 1.8 to 2.0
April Projections 3.1 to 3.4 1.9 to 2.3 1.8 to 2.0
Core PCE Inflation 2.3 to 2.5 1.5 to 2.0 1.3 to 1.8
June Projections 2.2 to 2.4 2.0 to 2.2 1.8 to 2.0
April Projections 2.2 to 2.4 1.9 to 2.1 1.7 to 1.9
Source: Table in the Minutes of the Federal Open Market Committee, October 28-29, 2008.
a. These projections use the price index for Personal Consumption Expenditures obtained from the Gross
Domestic Product accounts. The Core PCE is the PCE less food and energy.

14These projections represent the “central tendency” for each variable, which means that in computing the averages in
the table the three highest and lowest projections for each variable are excluded.

The Constitution grants Congress the power to “coin money, and regulate the value thereof.... ”
However, operational responsibility for making U.S. monetary policy has been delegated by
Congress to the Fed. Congress is still responsible for oversight, setting the Fed’s mandate and
approving the President’s nominations for the Fed’s Board of Governors, but several institutional 15
features grant it significant “independence” from the political process. The Federal Reserve
system is quasi-public in structure: it is owned by its member banks. The governors are appointed
to staggered 14-year terms, and can only be removed by Congress for cause. It is self-funded and
does not receive appropriations. While it must follow its congressional mandate, it has been
granted broad discretion to interpret and carry out that mandate as it sees fit on a day-to-day
basis. Most economists argue that good monetary policy depends on independence because it
reduces the temptation to raise inflation in the long run in order to lower unemployment in the
short run. Researchers have made cross-country comparisons to try to make the case that
countries with independent central banks are more likely to have low inflation rates and better 16
economic performance.
As a practical matter, the Fed’s mandate can be seen as a further source of political independence.
The Federal Reserve Act of 1977 (P.L. 95-188, 91 Stat. 1387) charged the Fed with “the goals of
maximum employment, stable prices, and moderate long-term interest rates.” Note that the Fed
controls none of these three indicators directly; it controls only overnight interest rates. Because it
has only one instrument at its disposal and three goals, there will be times when the goals will be
at odds with each other, and the Fed will have to choose to pursue one at the expense of the other
two. Critics have argued that the ambiguity inherent in the current mandate makes for less than
optimal transparency and accountability. It may also strengthen political independence if it allows
the Fed to deflect congressional criticism by pointing, at any given time, to whatever goal
justifies its current policy stance.
The most popular alternative to the current mandate is to replace it with a single mandate of price
stability. Under this proposal, the Fed would typically be given (or, under the version mooted by
Chairman Bernanke, give itself) a numerical inflation target, and would then be required to set 17
monetary policy with the goal of meeting the target on an ongoing basis. Proponents of inflation
targeting say that maximum employment and moderate interest rates are not meaningful policy
goals because monetary policy has no long-term influence over either one. They argue a mandate
that focused on keeping inflation low would deliver better economic results and improve
transparency and oversight. Opponents, including former Chairman Greenspan, say that the
flexibility inherent in the current system has served the United States well in the past 25 years,
delivering both low inflation and economic stability, and there is little reason to fix a system that
is not broken. They argue that some focus on employment is appropriate given that monetary

15For more information, see CRS Report RL31056, Economics of Federal Reserve Independence, by Marc Labonte.
16For a review of the research and criticisms, see CRS Report RL31955, Central Bank Independence and Economic
Performance: What Does the Evidence Show?, by Marc Labonte and Gail E. Makinen.
17See CRS Report 98-16, Should the Federal Reserve Adopt an Inflation Target?, by Marc Labonte and Gail E.

policy has powerful short-term effects on it, and that too great a focus on inflation could lead to 18
an overly volatile business cycle. Various forms of inflation targeting have been adopted abroad.

18See CRS Report RL31702, Price Stability (Inflation Targeting) as the Sole Goal of Monetary Policy: The
International Experience, by Marc Labonte and Gail E. Makinen.

The Federal Reserve has preferred to conduct monetary policy by setting a target for the federal
funds rate. This method has allowed the Federal Reserve to adopt an activist stance in the conduct
of monetary policy. The Board of Governors controls another interest rate, the discount rate.
Financial institutions can borrow on a temporary basis directly from the Federal Reserve at this
rate (that is, they can use the discount window). The Board can either grant or deny the loan. The
initiation of the loan, however, is at the discretion of the borrowing financial institution. In this
sense, the Federal Reserve is passive in the process. Although the discount rate has long been a
tool of central banking, the discount window has not been used much in the United States over
the past several decades until market turmoil in 2008 gave it a more permanent role. Financial
institutions prefer to borrow overnight in the federal funds market because they can obtain what
they need without having to subject their borrowing needs to the purview of the Federal 19
Reserve. In conducting monetary policy, the Board has, in the past, moved the discount rate in
sympathy with the federal funds target. For much of the past decade, the discount rate was set
slightly below the federal funds target.
To discourage financial institutions from borrowing at the discount window, lending rules were
altered in early 2003. Since that time, the discount rate has been set above the federal funds rate
target and is now a penalty rate. However, a change in the discount rate independent from a
change in the federal funds target can send a powerful message to financial markets. For example,
on August 17, 2007, the Board of Governors, concerned about the adequacy of liquidity in
national financial markets, reduced the discount rate for primary credit to 4¾% from 5¼%. Later,
on September 18, October 31, December 11, 2007, January 22 and 30, March 18, April 30,
October 8 and 29, and December 16, 2008, when the federal funds target was reduced, the
discount rate was also reduced, replicating past behavior by the Federal Reserve (in addition, on
March16, 2008, the discount rate was lowered without any change in the federal funds target).
However, in the current financial environment, the Fed has not discouraged banks in their use of
the discount window.

19A certain stigma was once attached to using the discount window to obtain reserves. Since banksborrow from their
depositors to acquire assets, it was thought to be a sign of unsound banking to also borrow from the Federal Reserve.

Since the amount of money is an important determinant of money spending, it might appear to
some as curious that the Fed does not target the money supply in the conduct of monetary policy.
Such a target has not been popular with the Federal Reserve. This is due, in part, to the fact that
until the early 1970s, the U.S. was a part of an international monetary regime based on fixed
exchange rates. Under such a regime, money supply targeting isn’t possible. However, after the
U.S. switched to using flexible exchange rates in the early 1970s, the Fed did define several
measures of money (designating them, ultimately, as M1, M2, and M3), published data on them
on a monthly basis, and set growth rate ranges for each on a annual basis.
Early on the Fed encountered problems with its defined measures of money. These monetary
aggregates were not stably and predictably related to money spending (in the technical language
of the economist, the demand for these measures of money was unstable). Hence, their usefulness
as a target for monetary policy was questionable and inferior to using an interest rate target. This 20
the Fed ultimately recognized. In its report to Congress, dated July 20, 1993, the Board of
Governors expressed considerable uncertainty about the usefulness of M2 and M3 as measures of
money and decided to de-emphasize both in its decision-making. While the board continued to set
growth rate ranges for each aggregate, it concluded:
With considerable uncertainty persisting about the relationship of the monetary aggregates to
spending, the behavior of the aggregates relative to their annual ranges will likely be of
limited use in guiding policy ... and the Federal Reserve will continue to utilize a broad range
of financial and economic indicators in assessing its policy stance.
This position was reaffirmed by the board during subsequent Monetary Policy (formerly called
Humphrey-Hawkins) hearings. However, in the Monetary Policy Report submitted to Congress
on July 20, 2000, the Board of Governors stated:
At its June meeting, the FOMC did not establish ranges for the growth of money and debt in
2000 and 2001. The legal requirement to establish and to announce such ranges had expired,
and owing to uncertainties about the behavior of the velocities of debt and money, these
ranges for many years have not provided useful benchmarks for the conduct of monetary
policy. Nevertheless, the FOMC believes that the behavior of money and credit will continue
to have value for gauging economic and financial conditions....
Even this view of the usefulness of the aggregates changed. The Board of Governors announced
in November 2005 that beginning in March 23, 2006, it would no longer publish data on M3. In
the words of the Board: “... publication of M3 was judged to be no longer generating sufficient

20For a discussion of their usefulness in the conduct of monetary policy, see CRS Report RL31416, Monetary
Aggregates: Their Use in the Conduct of Monetary Policy, by Marc Labonte and Gail E. Makinen; Dotsey, Michael,
Carl Lanta, and Lawrence Santucci, “Is Money Useful in the Conduct of Monetary Policy? Quarterly Review, Federal
Reserve Bank of Richmond, Vol. 86, No. 4 (Fall 2000), pp. 23-48, and Meyer, Laurence H. “The 2001 Homer Jones
Memorial Lecture, Washington University, St. Louis, Missouri, March 28, 2001. When this lecture was given,
Laurence Meyer was a governor of the Federal Reserve.

benefit in the analysis of the economy or of the financial sector to justify the costs of 21
Marc Labonte
Specialist in Macroeconomic Policy, 7-0640

Gail E. Makinen - Economic Policy Consultant, Government and Finance Division

21Monetary Policy Report to the Congress, February 15, 2006, p. 22.