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Conducting Monetary Policy

One of the most important jobs of the Federal Reserve is to keep our economy healthy. The Federal Reserve System has been given a dual mandate — it must pursue the economic goals of price stability and maximum employment. It does this by managing the nation's system of money and credit — in other words, conducting monetary policy.

The first part of the Fed's dual mandate is price stability — which means that the economy is not experiencing high or variable inflation or deflation. Experience has shown that the economy performs well when inflation is low. When inflation is low – and is expected to remain low — interest rates are usually low as well.

Economists like to argue that money belongs in the same class as the wheel and the inclined plane among ancient inventions of great social utility. Price stability allows that invention to work with minimal friction.

Former Chairman Ben Bernanke
Feb. 24th, 2006 speech at Princeton University

Low interest rates allow businesses to borrow money for expansion and hiring additional workers. Such an environment promotes low unemployment and allows the economy to achieve its growth potential.

The ability to maintain stable prices is a long-term measure of the Fed's success. To achieve this, the Fed sets a variety of targets, including:

  • the amount of money circulating in the economy,
  • the level of reserves held by banks, and
  • the level of interest rates.

The Fed constantly measures the effects of its policies on the economy. The Federal Reserve System has set a long-run goal for inflation at the rate of 2 percent. While, the inflation rate may fluctuate a bit, it should average 2 percent over the long-run.

The actions that the Fed takes today influence the economy and the inflation rate for some time to come. Policymakers must be forward looking and take action to head off inflation or deflation before either becomes a problem. Inflation isn't healthy for the economy, but neither is deflation.

Deflation occurs when the average price level is falling throughout the economy, so the inflation rate is negative. While this might sound good for consumers, it can cause some major problems for the economy. Note that this is different from disinflation.

Disinflation is a decrease in the inflation rate — say, from 4 percent to 3 percent a year. Notice that the economy still has a 3 percent inflation rate — the inflation rate is just lower than before.

The goal of the Federal Reserve System is to promote stable prices. When prices are stable, consumers and producers can make their spending and investing decisions without worrying that the value of their money will change dramatically — up or down — in the near future.

The second part of the Fed's dual mandate is maximum employment. Maximum employment is the level at which cyclical unemployment — the type that rises during economic downturns — is eliminated. The Federal Reserve has been given the task of using its monetary tools to boost an economy as it starts to weaken.

The first challenge is determining how to interpret the dual mandate. Of course, the Federal Reserve doesn't take a literal approach to the goal of maximum employment. In that case, our policies would need to be directed at getting everyone to work at least one hundred hours a week, and we would have to discourage senior citizens from retiring and young people from attending college instead of entering the labor force. Federal Reserve officials and other policymakers often refer to this aspect of the dual mandate as the goal of maximum sustainable employment, and they place particular emphasis on the word sustainable.

Frederic Mishkin
Apr. 10, 2007 speech at Bridgewater College

The dual mandate is a difficult objective because concentration on one variable puts the other at risk. For example, if the Fed were to attempt to drive unemployment to continually lower levels by pressuring interest rates lower and lower, consumers would borrow increasing amounts of money to buy houses, cars, furniture and vacations. Production would not be able to keep up with the demand for goods and the prices of those goods would begin to rise — inflation would likely get out of hand. On the other hand, if the Fed were to become overly concerned about inflation and refuse to allow the money supply to expand quickly enough, consumers would buy less and businesses would delay plans to expand — unemployment would likely rise, perhaps to painful levels.

Back to our car analogy — the dual mandate is like driving on an interstate with a minimum and maximum speed limit. The FOMC's goal is to keep the car — or in this case, the economy — going at a fast, but safe speed. If the car starts to slow or encounters a hill, the driver may have to give it a bit more gas to maintain speed, but when the car starts to go too fast, the driver will have to ease up on the gas or even tap on the brakes to slow its momentum. In this way the driver — or FOMC — must always be mindful of conditions and changes in the road ahead.