For context: New England Perspectives on Fed Policymaking
A “Fed Listens” Conference

So, what is monetary policy – and why does it matter?

The Federal Reserve was created by an act of Congress in 1913-14. Its charter has been amended numerous times since then, but an amendment made in 1978 delegates to the Fed two key responsibilities, which we refer to as the “Dual Mandate.” The first is maintaining “price stability;” the second is attaining “maximum sustainable employment.”

Monetary policy determines key interest rates on overnight borrowing, but that in turn influences the interest rates that matter most to households and businesses (such as mortgage rates, auto loan rates, business loan rates), as well as the value of the US dollar in foreign exchange markets and (to a lesser extent) the prices of stocks, housing, and corporate bonds.

The Fed aims to set its short-term interest rate so as to achieve our mandate: price stability and maximum sustainable employment over time.

A little more about the so-called dual mandate

The Fed interprets “price stability” to mean low and stable rates of inflation, the average rate at which prices of all goods and services in the economy are rising. The Fed employs a measure of inflation that is based on an array of goods and services – things like food and beverages, fuel, electricity, clothing, cars and trucks, healthcare costs, rent, prescription drugs, travel expenses, and the like. Since January of 2012, the policymaking committee of the Fed has agreed that an inflation rate of two percent is consistent with the notion of price stability.

Maximum sustainable employment is the level of employment at which the economy could function indefinitely without leaving workers who want to work unemployed on the one hand, and without putting significant strains on labor markets on the other. That level of employment is not something the Fed can determine, as it depends on the demographic make-up of the labor force and its educational attainment, among other factors. But we spend considerable effort in trying to estimate it as a guide to our policy.

How do we do this?

The Federal Open Market Committee (FOMC) is the monetary policymaking body of the Federal Reserve System. The FOMC is composed of 12 members--the seven members of the Board of Governors and five of the 12 Reserve Bank presidents, and is currently chaired by Jay Powell. FOMC members bring economic analysis and qualitative guidance from across the country to the rate-setting discussion. The FOMC releases a statement after each meeting explaining its decision regarding rates and providing general perspectives on the economy. All meetings are now accompanied by press conferences led by Chair Powell.

Now, let’s put it in recent context (How the Fed responded to the Great Recession)

In the wake of the recent Great Recession, the Fed kept the short-term interest rate that we control near 0 percent from late 2008 until December of 2015. We also purchased several trillion dollars of government-backed securities with the goal of further lowering longer-term interest rates (rates on mortgages, car loans, business loans) once our short-term interest rate hit the effective lower bound of about zero.

Since the beginning of the recovery in mid-2009, the economy has grown on average at about two and a quarter percent per year. This growth, in turn, has lowered the unemployment rate gradually from 10 percent to its current level in the mid-three percent range, a level we have not experienced since the late 1960s. Inflation during that period has been modest, lingering below two percent for a while, but fluctuating in a narrow range around 2 percent more recently.

Beginning in December 2015, the Fed started to gradually raise the short-term interest rate from near zero to its current level of 2.4 percent. That has led to a modest increase in mortgage rates, auto loan rates, and business lending rates, and an appreciation in the value of the dollar on foreign exchange markets. Economic growth has averaged about 2.5 percent over that period, unemployment has declined gradually by almost two percentage points, and inflation has stabilized near two percent.

Two important concerns

Despite relatively positive signs in the economy, the Fed faces a number of significant challenges going forward.

A low interest rate environment will limit our ability to lower interest rates to offset any future recession. We are discussing ways to provide the desired support to the economy even as we live with low average interest rates. As discussed above, one option that we employed during the Great Recession was to purchase long-term government securities, with the aim of directly lowering the longer-term interest rates on these and similar securities.

We’re happy to enjoy the benefits of tight labor markets. But as they draw in more workers who might not otherwise find employment, we are cautious about pushing things too far. How best to balance the benefits of tight labor markets with the potential costs of over-stretching the economy, perhaps building imbalances that ultimately unravel into a recession? History is rife with examples of such imbalances: in financial markets (the recent financial crisis), in misallocations of business investments (which occurred in the late 1990s in the wake of the “dot-com” bubble), in over-investment in housing (which occurred in the run-up to the financial crisis), or in rising inflation. This concern is particularly important because in most recessions, lower-income, lower-tenure and minority workers are the first to lose their jobs.

The goal of this event is to help us address these concerns, as well as understand the real-world impact Fed policymaking has on a variety of groups across our region. A few other central banks, such as the Bank of Canada, have formal processes for evaluating monetary policymaking. We have not prior to this year. This is our first effort at putting together a process to more systematically take stock of our policy decisions, gathering a variety of views that we believe will help us to assess whether it’s time to change – or continue – the way we do monetary policy.