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The US Federal Reserve's monetary policy decisions are guided by the goals of maximum employment and stable prices.

Maximum employment is generally understood to mean a low and sustainable unemployment rate, but it is not clearly defined. Price stability, on the other hand, has been explicitly defined by the Fed since 2012 as 2% inflation — as measured by the personal consumption expenditure price index — over the long run. Inflation at this level is thought to be low enough that it does not effectively alter or distort the decisions of households and businesses.

Policy targets

The Federal Reserve's three main policy targets are the federal funds rate, the size of its balance sheet, and market expectations of its future policy moves.

The federal funds rate is the rate of interest at which banks lend reserve balances to each other overnight on an unsecured basis. A target range for the funds rate is determined by the Federal Open Market Committee at their regularly scheduled meetings, and, occasionally, outside those meetings as circumstances warrant. This range has historically been 25 basis points wide.

Changes in the size and composition of the Federal Reserve's balance sheet determine the amount of liquidity in the banking system. On the asset side, the Fed's balance sheet is primarily made up of US Treasury securities and mortgage-backed securities, which are purchased under what are known as "large scale asset purchase" programs, and various loans.

Tools of monetary policy

When the Fed seeks to make monetary policy more accommodative, they can conduct outright purchases of Treasuries and mortgage-backed securities in a process known as quantitative easing, or QE. When they seek to make policy more restrictive, they can sell assets or simply allow them to mature and run-off their balance sheet without reinvestment through quantitative tightening, or QT. Purchasing securities on the open market through a network of primary dealers puts upward pressure on the prices of those securities and lowers the yields.

QE and QT are important complements to the Fed's control of the federal funds rate because it helps to lower or raise the yields on longer-term maturities. By using QE/QT to help steer the entire yield curve, the Fed can better influence yields on longer-dated corporate bonds, which influence business fixed investment, and on mortgages, which are an important determinant of housing demand and construction.

Reserves are now so ample that the federal funds rate would fall all the way to zero if not otherwise supported. Under the current ample reserves regime, the Fed controls the federal funds rate primarily through two administered rates: the interest on reserve balances (IORB) and the rate offered at the overnight reverse repo facility (ON RRP). The IORB is the rate paid by each Federal Reserve Bank to its member institutions on the reserves held overnight in their Fed accounts. A member bank will not choose to lend at a rate below the IORB it can earn by holding reserves.

Money market funds, government-sponsored enterprises, and primary dealers with excess cash to invest or lend also participate actively in the overnight funding market. Because these entities do not earn the IORB, they at times lend funds at rates below IORB. The Fed enhances its control of overnight funding rates by offering the ON RRP facility to this set of market participants. This is economically equivalent to an overnight loan made to the Fed, or an overnight deposit at the Fed. The ON RRP rate works similarly to the IORB rate by providing a floor on the overnight lending rates offered by this broader set of market participants.

The Fed uses a communication strategy known as forward guidance to align market expectations with the likely course of future monetary policy to influence longer-term yields. By influencing market expectations of the future path of the federal funds rate, the Fed influences the expected path of other short-term rates. Since long-term yields are determined by the expected path of short-term yields and a term premium, using forward guidance gives the Fed some additional control over longer-term yields.

Transmission channels and effects

Financial conditions are the channels underlying the relationships that govern how the Fed influences macroeconomic outcomes. The three main channels are interest rates, equity values, and the dollar exchange rate.

The Fed's efforts to influence market interest rates flow through to fixed- and floating-rate mortgages, significantly influencing the cost of homeownership and hence the demand for housing.

Stock prices, or more broadly equity values, are also influenced by the general level of interest rates. Most modelling of equity valuations involves discounting of future expected dividends at some future discount rate or interest rate.

Since capital is mobile globally, investors will move funds between countries to achieve higher yields. Policy-induced changes to interest rates in the US are felt globally; when US interest rates rise relative to those abroad, or foreign yields fall relative to those in the US, investors typically will attempt to move capital into the US to take advantage of the now relatively higher US yields. This involves buying dollars with foreign currency, which, when enough money follows this path, tends to raise the value of the dollar and weaken the value of the other currency.

On balance the rise in the dollar spells lower net exports and therefore, lower GDP Because the prices of imports are directly measured in the key price indexes of final consumer goods and services such as the CPI and PCE price index, the increase in the dollar directly puts downward pressure on inflation by these measures.

Taken together, the macroeconomic effects of the transmission of monetary policy through financial conditions can have a profound impact on the demand side of the economy. The Federal Reserve and their monetary policy actions can influence inflation in their capacity to stimulate or dampen demand, to the extent that inflation results from an imbalance in supply and demand. The Fed's credibility to achieve their inflation target and thereby anchor inflation expectations can also influence inflation. Monetary policy operates with long and variable lags, and the Fed must remain adaptable to unforeseen developments.

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This article was published by S&P Global Market Intelligence and not by S&P Global Ratings, which is a separately managed division of S&P Global.