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Good to Know: The Federal Reserve and U.S. monetary policy

The Fed is getting some good press. So what exactly is the Fed, and what does it do?

- January 15, 2024
U.S. Federal Reserve Bank
Federal Reserve Board Building, Washington, D.C. (cc) Rafael Saldaña

After months of criticism for its handling of rising inflation, last month the Federal Reserve received positive coverage across the news media, from the Wall Street Journal to the New York Times. Fed policies, in combination with administration actions and market changes, appear to be guiding the U.S. economy to a “soft landing.” In a soft landing, inflation lessens without tipping the economy into a recession or higher unemployment levels. 

Even if the Fed succeeds, it is likely to find itself in presidential campaign crosshairs. The Federal Reserve has long been a target for populist anger, both from the left and right. Many candidates criticize the Fed’s outsized impact on the economy, including the Republican presidential frontrunner Donald Trump in the past, Ron DeSantis during Republican primary debates, and continued Republican senators’ pushback against the Fed’s bond-buying policies

To help you join the conversation, here are three things to know about the Fed.

1.     Monetary policy

Under a mandate set by Congress and the president in the Federal Reserve Act, the Federal Reserve undertakes monetary policies designed to influence both inflation and unemployment. The Fed is one of the few central banks around the world that has two mandates, rather than a single directive to keep prices low and steady. Arguably, the Fed’s so-called dual mandate* of stable prices and full employment has a built-in trade-off. Restrictive monetary policies targeting inflation (such as higher interest rates) may constrain job and wage growth; less restrictive policies may spur spending, investment, and hiring in the short term but potentially drive up inflation in the long term. First theorized in 1958 by W.H. Phillips, this conflict between the Fed’s primary goals has mixed empirical evidence. But balancing the two goals nevertheless creates policy tension for internal decision-makers.

Whether the Fed appears to focus on price stability or employment generates distinct policy preferences among external economic interests such as unions and the financial industry and, in turn, the politicians aligned with them. Additionally, because the U.S. dollar “floats” on the international market, the Fed’s interest rate announcements influence the relative price of the dollar and, thus, the relative costs of imports and exports. Although the U.S. trade deficit is outside of the Fed’s direct mandate, the roll-on effect of its monetary policy decisions creates another set of economic and political interests with strong preferences for Fed policy decisions. For instance, because interest rates affect the value of the dollar in international markets, the Fed’s choice of whether to lower (or raise) interest rates matters greatly to exporters and importers.

2.      Federal Reserve independence 

Congress designed the Federal Reserve in response to the devastating financial crisis of 1907. In doing so, it worked to balance the competing demands of populists, progressives, and bankers, while providing just enough government oversight to gain the acceptance by a Democratic Congress and President Woodrow Wilson. The structure outlined in the Federal Reserve Act of 1913 created an arrangement in which the Fed today can exercise autonomy in making monetary policy, while still remaining accountable to Congress via its mandate, reporting, and auditing mechanism. (The mandate specifies which economic conditions the Fed can respond to.) That autonomy was controversial at the time – and remains controversial.

Here’s how it works today. The president appoints and the Senate confirms the seven members of the Board of Governors for 14-year non-repeatable terms and the chair and two vice-chairs of the Board of Governors for 4-year repeatable terms. Notably, the Federal Reserve chair and vice-chair nominations lag presidential terms by two years and board members’ terms span multiple administrations. Board members can only be removed “for cause” and not for their policy choices. Whether or not the president has the legal authority to remove the chairs has never been tested.

The Board of Governors supervises 12 regional Federal Reserve Banks. These regional reserves are only quasi-public bodies: Banks in the region select a majority of the banks’ directors, while the Fed Board selects the remaining and must sign off on the selection of presidents who lead the regional banks. Their selection does not require confirmation by the Senate.

Decision-making on monetary policy occurs within the Federal Open Market Committee (FOMC). The 12 voting members of the FOMC comprise a mix of politically appointed Board of Governors members and non-politically appointed regional bank presidents (the president of the Federal Reserve Bank of New York and four of the remaining 11 regional Reserve Bank presidents, who serve one-year terms on a rotating basis). FOMC holds at least eight scheduled meetings a year to vote on policy changes, with more if economic conditions necessitate.

At the meetings, staff from the Board of Governors, a senior official from the Federal Reserve Bank of New York, and all 12 regional Reserve Bank presidents (regardless of voting status) present economic assessments of international, national, and regional conditions that might influence monetary policy decisions. FOMC meetings are not open to the public, and the extent of public disclosure has varied since its inception. Currently, the FOMC releases an immediate statement and detailed minutes within three weeks, including individual votes.

3.      Central banks

While far from the first central bank, the Federal Reserve set the pattern for today’s model of independent central banks. At the start of the 20th century, the world had only 18 central banks, none of them independent. By the end of the 20th century, the world had almost 200, with 80% to 90% of them considered independent. Still, no other central bank has the same ability to move not just domestic, but also international markets.

Current debates

1.      Should the Federal Reserve be more accountable to the president’s preferences; is it already too responsive; or is the Fed’s independence a myth?

Notably, before the Fed board cut interest rates in 1971, President Richard Nixon privately advised then-Fed Chairman Arthur Burns to “Just kick ’em up the rump a little” to get his way. President Trump attempted a modern version by publicly denouncing “the boneheads” at the Federal Reserve and tweeting at them, arguably with some effectiveness. However, the president and Congress could structurally change the system. Trump considered adding partisan figures to the board, for instance. And in 2022, Republican senators proposed restructuring the Fed and increasing political oversight by requiring the regional Federal Reserve Bank presidents to be appointed by the president and confirmed by the Senate. Congress today is divided over whether to allow the Fed to develop a digital currency.

2.      Should the Federal Reserve be restructured to better represent domestic interests and global concerns?

The original distribution of regional Federal Reserve Banks matched the contemporary economic conditions, but the U.S. population and economy have shifted west greatly since 1913. The 12th district (headed by the Federal Reserve Bank of San Francisco) has tripled in population. Some argue that it is time to reconsider the districts. On the flip side, the Fed has varied over time in how much it considers its policies’ influence on global markets. Some have argued that the Fed should consider a “foreign policy“ as part of its international role.

 * Note: The dual mandate arises from the 1977 amendment to the Federal Reserve Act, which directed the Board of Governors and the Federal Open Market Committee (FOMC) to conduct monetary policy “so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.” The Fed argues that moderate long-term interests arise under conditions of full employment and stable prices, hence a “dual mandate.”

Further reading

Last updated: January 10, 2024

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