Monetary policy is how a central bank influences the demand, supply and price of money, as well as credit in order to direct the economic objectives of a country. The Federal Reserve, also known as the Fed, was given the authority to formulate U.S. monetary policy following the Federal Reserve Act of 1913. To do so, the Fed uses three important tools, which are open market operations, the discount rate, and reserve requirements. In the opinion of Kavan Choksi UAE, within the Federal Reserve, the FOMC or Federal Open Market Committee is responsible for implementing open market operations. On the other hand, its Board of Governors looks after the discount rate and reserve requirements.
Kavan Choksi UAE sheds light on how the Federal Reserve drives Monetary Policy
The actions taken by the Federal Reserve or the Fed toward its goal of a healthy economy essentially forms the basis of the United States monetary policy. The Fed has multiple tools at its disposal that helps drive monetary policy. The of interest rates, specifically the federal-funds rate, is the most widely known tool among them.
The Fed-funds rate basically is the interest rate that banks shall charge other financial institutions in exchange for lending them cash. This rate, in turn, has a major influence on the rates charged by banks to consumers for financial instruments like loans and credit cards. A higher interest rate helps in curbing demand and reins in inflation. On the other hand, a lower interest rate shall boost demand in the economy and heighten inflation. In simple words, if an economy is overactive, the Fed shall try to curb it by raising the interest rates. But if the economy is weak, then the Fed would do just the opposite to encourage economic activity.
In addition to the Fed-fund rate, there are multiple other tools that the Fed may use to enact monetary policy. This includes:
- Forward guidance: This would involve communicating with the public in order to set expectations about the economy. In many situations, expectations end up becoming self-fulfilling. Therefore, the public ultimately manifests what the Fed has told them to expect.
- Asset purchases: Also known as quantitative easing, this involves buying large quantities of longer-duration securities in order to boost demand and lower their overall yield. The goal here is to lower interest rates on longer-duration and riskier forms of credit like mortgages. If the Fed-fund rate is already at its lowest level and the economy requires further incentive, the Fed might use quantitative easing for stimulating aggregate demand. This entails the purchase of extra longer-duration securities like government bonds or mortgage-backed securities, which helps increase the Fed’s balance sheet. This consequently encourages lower rates on the relevant assets.
- Reserve requirements: As per this tool, the Fed may Fed can increase the minimum sum that commercial banks must hold in reserves.
As Kavan Choksi UAE mentions, the Federal Reserve comprises the Board of Governors, 12 Federal Reserve Banks and the FOMC. The FOMC meets at least eight times a year for the purpose of voting on monetary policy decisions like interest rates.
