Monetary policy, as its name implies refers to the policies conducted by the central bank (in the United States, this is the Federal Reserve) to affect the country’s money supply and demand in order to achieve important macroeconomic variables such as stable inflation and high employment. Contrary to popular misconception, while the Federal Reserve does change interest rates in order to conduct monetary policy, the Federal Reserve does not itself target interest rates and interest rates by themselves do not constitute policy, they are a principal tool of the Federal Reserve.
In the long-run, money is neutral (“monetary neutrality”). In other words, monetary policy over the long-run can only affect nominal variables, not real variables. If wages and prices are perfectly flexible (i.e. they can swiftly adjust), if the money supply doubled overnight, prices and wages would merely double and real variables like production and employment would remain unchanged. However, in the short-run, frictions like wage and price-stickiness mean that monetary policy can be highly effective.
Consider a highly simplified economy that produces a single good. In this economy, prices are sticky (i.e. they don’t change in the short run). Out of nowhere, the money supply in the country doubles so everyone has twice as much money as before. Since prices remain the same, the now-richer citizens want to buy substantially more than before and companies expand production accordingly. Over time, prices rise and output returns to its normal level. A critical feature of this simplified example is that the monetary shock was unexpected: if everyone knew the money supply doubling was coming, they could raise prices in anticipation of the incoming surge (inflation) and the effect would not come. This helps explain why central banks cannot permanently goose the economy through hyper-expansionary policy: eventually it will only result in inflation.
Now that we see how monetary policy can affect the economy, it’s worth exploring how the Federal Reserve can actually affect the money supply and interest rates. They have a variety of tools at their disposal.
First, they can conduct open market operations, which is when the Trading Desk at the Federal Reserve Bank of New York buys and sells securities from banks. If the Fed buys $1 trillion of securities (using Treasuries) from banks, they are swapping out assets for $1 trillion in cash (they do not actually give physical cash–they instead debit the banks’ master account at the Federal Reserve in “reserves”). As a result, the banks are now more cash-flush and with more money chasing the same lenders, interest rates will fall. If the Fed sells $1 trillion of securities they hold back to the banks, they then are removing $1 trillion in money from the system and raise interest rates. When the Federal Reserve engages in large-scale operations and buys securities other than Treasuries (such as mortgage-backed securities), this is called “quantitative easing”. Lowering the rate of these purchases is called “tapering”.
Second, they can raise or lower the interest paid on excess reserves (IOER). Major banks all have master accounts at the Federal Reserve where they can park their money. The Federal Reserve pays interest on those reserves. When that interest rate is higher, banks are happier to keep their money parked at the Fed instead of lending it and, as a result, the interest rate economy-wide rises and vice-versa. The IOER rate generally places a floor on economy-wide interest rates. The Federal Reserve also has some lesser tools, including changing the rate by which the Federal Reserve directly lends to banks (called the discount window, and is a loose ceiling on economy-wide interest rates), but in practice banks rarely use this practice because it is seen as a sign of weak finances. The Fed can also lower reserve requirements to stimulate lending (and thus money supply), but since 2008 reserve requirements have rarely been a binding constraint on lending activity.
Third, and perhaps most significantly, the Fed can engage in forward guidance (a.k.a. “expectations management”). The Federal Reserve and its chair will release statements where they clearly lay out their plan for the future. It may seem counterintuitive why this is so powerful, but credibility is the Federal Reserve’s most powerful weapon. If every firm thinks that inflation is spiraling out of control–they will start to raise prices preemptively, creating a self-fulfilling cycle. However, if the Federal Reserve can credibly signal that they will do whatever it takes to lower inflation, firms won’t hike prices prematurely, thus lowering inflation without lifting a finger. As a result, the Fed can actually avoid having to take painful dramatic action to stave off inflation, as long as they have credibility.
In general, the Federal Reserve tends to undertake expansionary monetary policy during recessions and then reduce that support during expansions. However, if the cause of the recession is a supply shock (such as the 1970s oil embargo or the 2020 COVID closures), monetary policy can do less to impact real variables. In those cases, aggressive money supply growth can actually cause stagflation (high inflation, high unemployment) as more money chases fewer goods. That’s not to say it has no positive effects–many credit the Federal Reserve’s dramatic actions during spring 2020 for staving off a financial collapse by injecting needed liquidity into the system–but instead that its effects are different than in a typical demand recession like 1992, 2001 or 2008.
A common mistake observers make is conflating interest rates with the stance of monetary policy. In a vacuum, it’s impossible to know whether a 1% interest rate is hawkish (contractionary) or dovish (expansionary). If the “neutral” interest rate is very low, such as in Japan or Europe in 2013 (which generally reflects low outside opportunities to make money), then a 1% interest rate is contractionary. In a hot economy (such as the United States in the late 1990s), a 1% interest rate would be highly inflationary.