The U.S. economy is dependent on the efforts of the
Federal Reserve to stimulate the economy through
monetary policy. Like the central banks in other countries,
the efforts of the Fed to maintain key interest rates and
employment are necessary throughout economic cycles.
In recent decades, through several “crisis” periods, the
Fed has responded to adverse events in the economy
to improve conditions. The decisions of the central
bank often influence the direction of the stock market,
with low rates often resulting spurring on rallies. Those
decisions also are aimed at maintaining an inflation rate
that the Fed considers ideal.
The Fed has always focused its attention on monetary
policy as a key tool in its arsenal.
In order to meet its goals with respect to maximum
employment, stable prices and moderate long-term
interest rates, the Fed uses monetary policy. This
includes managing short-term interest rates and
having an influence on the availability and cost
The manipulation of monetary policy allows the Fed
to influence currency exchange rates, stock prices
and wealth as indirect consequences.
There were some changes to monetary policy that
emerged from the financial crisis beginning in 2007.
Prior to the financial crisis, the Fed had bought or
sold securities that were issued or backed by the U.S.
government in the open market to keep the federal funds rate at, or near, a target set by the Federal Open Market Committee (FOMC). Changes to the federal funds rate would result in changes to other interest rates earned by
those saving money or borrowing money.
By the end of 2008, the FOMC lowered their target rate
to near zero. After this, the Fed began buying up large
amounts of longer-term government securities to bring
down longer term interest rates. By late 2014, the Fed
also announced plans to normalize monetary policy
because the U.S. economy was now in better shape with
near maximum employment. In December of 2015, the
FOMC voted to raise its target for the federal funds rate.
A New Day
Fast forward to 2020. On August 27, the Fed announced
a historic change to its previous interest rate policy with
more of an emphasis on increasing employment. In the
past, the Fed’s target rate for inflation had been 2 percent
during times of economic expansion.
This shift will also result in keeping interest rates lower.
With the downturn in the economy that has resulted
from the coronavirus pandemic, the Fed is more likely
to maintain its key interest rate near zero into the
Part of the change in the Fed’s thinking has been
the belief that “a robust job market can be sustained
without causing an outbreak of inflation,” according
to Fed Chair Jerome Powell.
One near term effect this would have on the markets is
that it renews interest in equities and takes money out
of the bond market. That helped the market with some
gains in late August before stocks in the tech sector fell
out of favor.
The changes to the Fed’s monetary policy framework
have resulted from a GDP that has not been as robust
and inflation rates that have remained below the Fed’s
2 percent target. That was the case in February when
the unemployment rate was only 3.9 percent.
The new approach would allow the inflation rate to rise
above 2 percent for some time as long as it did not get
out of hand. This policy flies in the face of previous Fed
rules, which were targeted at maintain very low inflation.
As the U.S. eventually emerges from the pandemic, the
shift in the Fed’s policies will be needed to maintain a
healthy economy in future years.