Part 2: Monetary Policy
Monetary Policy Report submitted to the Congress on July 5, 2024, pursuant to section 2B of the Federal Reserve Act
The Federal Open Market Committee has held the federal funds rate steady...
The Federal Reserve conducts monetary policy to promote its statutory goals of maximum employment and price stability. (See the box "Monetary Policy Independence, Transparency, and Accountability.") Inflation has eased over the past year but has remained elevated while the economy has continued to expand at a solid pace. Job gains have been strong, and the unemployment rate has remained low. Against this backdrop, the Federal Open Market Committee (FOMC) has maintained a restrictive stance of policy at recent meetings to keep demand in line with supply and reduce inflationary pressures. Since its July 2023 meeting, the Committee has maintained the target range for the federal funds rate at 5-1/4 to 5-1/2 percent, after having raised the target range a total of 525 basis points starting in early 2022 (figure 46). The FOMC's policy tightening actions and current policy stance reflect the Committee's strong commitment to return inflation to its 2 percent objective. Restoring price stability is essential to achieving maximum employment and stable prices over the long run that benefit all Americans.
With labor market tightness continuing to ease gradually and inflation easing over the past year, the risks to achieving the Committee's employment and inflation goals have moved toward better balance. The Committee remains highly attentive to inflation risks and is acutely aware that high inflation imposes significant hardship, especially on those least able to meet the higher costs of essentials, like food, housing, and transportation. In considering any adjustments to the target range for the federal funds rate, the Committee will carefully assess incoming data, the evolving outlook, and the balance of risks. The Committee does not expect it will be appropriate to reduce the target range until it has gained greater confidence that inflation is moving sustainably toward 2 percent.
Monetary Policy Independence, Transparency, and Accountability
Monetary policy is carried out by the Federal Reserve in pursuit of maximum employment and price stability—the dual-mandate goals assigned to it by Congress. Congress has also given the Federal Reserve operational independence. Under this arrangement, the Federal Reserve, rather than other parts of the government, makes determinations about the monetary policy actions that are most appropriate for achieving the dual-mandate goals. This arrangement allows monetary policy decisions to be insulated from short-term political influences.
There is broad support for the principles underlying independent monetary policy. It is widely understood that the monetary policy actions that deliver maximum employment and price stability in the longer run may involve restraining measures that entail short-run economic costs, while actions that raise output and employment to unsustainable levels have no long-run real benefits and may lead to elevated inflation rates. These considerations highlight the value of monetary policy being carried out by an independent agency whose decisions are based on the congressionally assigned dual mandate.1 Operational independence of monetary policy has become an international norm, and economic research indicates that economic performance has tended to be better when central banks have such independence.2
Because the Federal Reserve is accountable to Congress and has been granted independence in the setting of monetary policy, it is vitally important that the Federal Reserve be transparent to Congress and the American people about its monetary policy actions. Transparency requires that the Federal Open Market Committee (FOMC) explain the reasons for its monetary policy decisions, including how these decisions relate to its statutory goals. This feature of transparency underlies the FOMC's assessment that "transparency and accountability...are essential in a democratic society." 3
Specifically, monetary policy transparency consists of the process in which the Federal Reserve provides to the American people and their elected representatives information about the objectives and strategy of monetary policy, announces its decisions regarding the setting of its policy instruments, explains the reasoning behind those decisions, and provides detailed records of monetary policy committee meetings. The Federal Reserve promotes monetary policy transparency in multiple ways, including through testimony given by Federal Reserve policymakers at congressional hearings, speeches by the Chair and other FOMC meeting participants on economic and policy developments, the FOMC's postmeeting statements, the published minutes and transcripts of each FOMC meeting, the quarterly Summary of Economic Projections (SEP), the Chair's press conferences, and dialogues between FOMC participants and community representatives across the country.
A strong emphasis on transparency has characterized the past 30 years of U.S. monetary policy. Previously, Federal Reserve officials from the 1950s to the 1980s regularly gave congressional testimony and speeches on monetary policy. Nevertheless, important aspects of transparency were missing. The FOMC in these decades did not provide, in a systematic and timely manner, information on its monetary policy decisions.4 In particular, it did not follow a regular practice of issuing, after policy meetings, an announcement of Committee policy actions and the rationale for those actions. The situation changed starting in the mid-1990s. Reflecting on this change, in 2023 Chair Powell noted: "Over the past several decades we have steadily broadened our efforts to provide meaningful transparency about the basis for, and consequences of, the decisions we make." 5
The shift to greater transparency has reflected not only the fact that transparency supports the Federal Reserve's accountability, but also widespread acceptance that transparency can contribute to the effectiveness of monetary policy. Explanations to the general public of the FOMC's decisions, strategy, and plans tend to enhance the effects of monetary policy actions on financial conditions, economic activity, and inflation. For example, a numerical inflation objective can be helpful in anchoring longer-run inflation expectations, while forward guidance (which is at times provided in FOMC statements) about the federal funds rate can influence key longer-term interest rates by shaping the private sector's assessment of the likely future course of the funds rate. Consequently, the FOMC has observed that clarity about monetary policy decisions "increases the effectiveness of monetary policy." 6
Today the acceptance of the need for, and benefits of, monetary policy transparency is reflected in the large volume of material that the FOMC and the individual Committee participants provide about their decisions and thinking.7 A major step in the direction of greater transparency took place in 1994, when announcements of policy changes began to be issued after FOMC meetings. By the end of the decade, these releases had evolved into the now standard and key part of the Committee's policy communications—a statement released by the Committee after each meeting that announces the decision on the federal funds rate target range and any other policy actions, puts that decision in the context of the Committee's assessment of incoming data and the economic outlook, and gives the record of the vote on the action.8 Further information about Committee decisions is provided via FOMC meeting minutes, released three weeks after each FOMC meeting (a shorter lag than that prevailing until the mid-2000s). After five years, transcripts of the FOMC meetings are made public.
At the end of 2007, the FOMC began publishing, on a quarterly basis, the SEP, which distills information about individual meeting participants' economic projections. Since then, numerous features have been added to the SEP, including longer-run projections in 2009 and federal funds rate projections in 2012. In 2011, Chair Bernanke started holding regular postmeeting press conferences. In 2019, Chair Powell initiated the practice of holding press conferences after every FOMC meeting.
With regard to its strategy, in January 2012 the FOMC issued a Statement on Longer-Run Goals and Monetary Policy Strategy, or "consensus statement." The consensus statement has been reaffirmed in the years since 2012, and it has been revised several times. From its inception, the consensus statement made the price-stability component of the dual mandate numerically precise by indicating that Federal Reserve policymakers interpret it as corresponding to a 2 percent longer-run inflation rate (in the personal consumption expenditures price index). Also in the area of strategy, in 2018 the Federal Reserve launched the practice of having a review of monetary policy strategy, tools, and communication practices roughly every five years. The first such framework review took place from 2019 to 2020. An innovation of this review was the holding, around the country, of Fed Listens events, consisting of a dialogue between Federal Reserve policymakers and community members on monetary policy and economic issues. The Federal Reserve has continued to hold Fed Listens events between the periods of framework review.
The framework review process also included internal FOMC deliberations. These deliberations took place at Committee meetings and were detailed in the publicly released FOMC meeting minutes. The Federal Reserve staff memos that served as an input into these deliberations were released publicly after the completion of the 2019−20 review. The next framework review is scheduled to begin later this year.
Along with the transparency-enhancing activities, documents, and statements described earlier, further information on monetary policy decisions is provided in the frequent speeches, interviews, and testimony given by FOMC meeting participants.
1. The same basic case for independence has been sketched by successive Federal Reserve Chairs. For example, Paul Volcker noted in congressional testimony in February 1982 that "Congress deliberately set us up with an insulation from that kind of political pressure, and that that is a trust that you have given us and that we mean to discharge," and he elaborated in July 1987: "[Not] responding to all the short-term political considerations that exist to produce easier money than the basic situation warrants and the long-term health of the currency and the economy warrants...[is] the basic justification for the independence of the Federal Reserve." Alan Greenspan testified in October 1993 that there was "an awareness that independence of the central bank is an element in keeping inflation down." Ben Bernanke remarked in May 2010: "It is important that we maintain and protect...the ability of central banks to make monetary policy decisions based on what is good for the economy in the longer run, independent of short-term political considerations." Also in 2010, Janet Yellen (who was at the time Vice Chair of the Federal Reserve Board and who later served as Federal Reserve Chair) observed: "The principle of central bank independence in the conduct of monetary policy is widely accepted as vital to achieving maximum employment and price stability." Chair Jerome Powell likewise stated in January 2023 that "the case for monetary policy independence lies in the benefits of insulating monetary policy decisions from short-term political considerations." See Paul A. Volcker (1982), "Panel Discussion," in Federal Reserve's First Monetary Policy Report for 1982, hearings before the Committee on Banking, Housing, and Urban Affairs,U.S. Senate, February 11 and 25, Senate Hearing 97-48, 97th Cong. (Washington: U.S. Government Printing Office), quoted text on p. 28, https://fraser.stlouisfed.org/title/monetary-policy-oversight-671/federal-reserve-s-first-monetary-policy-report-1982-22312; Paul A. Volcker (1987), remarks in Federal Reserve's Second Monetary Policy Report for 1987, hearing before the Committee on Banking, Housing, and Urban Affairs,U.S. Senate, July 23, 100th Cong. (Washington: U.S. Government Printing Office), quoted text on p. 45, https://fraser.stlouisfed.org/title/monetary-policy-oversight-671/federal-reserve-s-second-monetary-policy-report-1987-22373; Alan Greenspan (1994), remarks in The Federal Reserve Accountability Act of 1993, hearing before the Committee on Banking, Finance, and Urban Affairs, U.S. House of Representatives, October 13, 1993, 103rd Cong. (Washington: U.S. Government Printing Office), quoted text on p. 40, https://fraser.stlouisfed.org/title/federal-reserve-accountability-act-1993-1154; Ben S. Bernanke (2010), "Central Bank Independence, Transparency, and Accountability," speech delivered at the Institute for Monetary and Economic Studies International Conference, Bank of Japan, Tokyo, May 25, quoted text in paragraph 2, https://www.federalreserve.gov/newsevents/speech/bernanke20100525a.htm; Janet L. Yellen (2010), "Macroprudential Supervision and Monetary Policy in the Post-crisis World," speech delivered at the Annual Meeting of the National Association for Business Economics, Denver, Colo., October 11, quoted text in paragraph 44, https://www.federalreserve.gov/newsevents/speech/yellen20101011a.htm; and Jerome H. Powell (2023), "Panel on ‘Central Bank Independence and the Mandate—Evolving Views,' " speech delivered at the Symposium on Central Bank Independence, Sveriges Riksbank, Stockholm, Sweden, January 10, quoted text in paragraph 2, https://www.federalreserve.gov/newsevents/speech/powell20230110a.htm. A detailed discussion of the issues involved is provided by Paul Tucker (2018), Unelected Power: The Quest for Legitimacy in Central Banking and the Regulatory State (Princeton, N.J.: Princeton University Press). Return to text
2. See, for example, Christopher Crowe and Ellen E. Meade (2008), "Central Bank Independence and Transparency: Evolution and Effectiveness," European Journal of Political Economy, vol. 24 (December), pp. 763–77. https://cepr.org/voxeu/columns/recent-trends-central-bank-independence. Return to text
3. See the FOMC's Statement on Longer-Run Goals and Monetary Policy Strategy (quoted text in paragraph 1), available on the Board's website at https://www.federalreserve.gov/monetarypolicy/files/fomc_longerrungoals.pdf. More specifically, paragraph 1 of this statement indicates that "the Committee seeks to explain its monetary policy decisions to the public as clearly as possible" and that "such clarity facilitates...transparency and accountability, which are essential in a democratic society." In the same spirit, a major contribution to the research literature on the practice of monetary policy—the 1999 book Inflation Targeting—earlier observed: "Transparency and communication together enhance accountability." See Ben S. Bernanke, Thomas Laubach, Frederic S. Mishkin, and Adam S. Posen (1999), Inflation Targeting: Lessons from the International Experience (Princeton N.J.: Princeton University Press), quoted text on p. 296. Return to text
4. See David E. Lindsey (2003), "A Modern History of FOMC Communication: 1975−2002," memorandum to the Federal Open Market Committee, Board of Governors of the Federal Reserve System, Division of Monetary Affairs, June 24, https://www.federalreserve.gov/monetarypolicy/files/FOMC20030624memo01.pdf; and Ben S. Bernanke (2013), "A Century of US Central Banking: Goals, Frameworks, Accountability," Journal of Economic Perspectives, vol. 27 (Fall), pp. 3−16. Return to text
5. See Powell, "Panel on ‘Central Bank Independence,' " in box note 1 (quoted text in paragraph 4). See also Alan S. Blinder (2002), "Through the Looking Glass: Central Bank Transparency," CEPS Working Paper 86 (Princeton, N.J.: Princeton University Department of Economics, December), https://gceps.princeton.edu/wp-content/uploads/2017/01/86blinder.pdf. Return to text
6. See the FOMC's Statement on Longer-Run Goals and Monetary Policy Strategy, in box note 3 (quoted text in paragraph 1). Return to text
7. For further details, see Board of Governors of the Federal Reserve System (2019), "Review of Monetary Policy Strategy, Tools, and Communications," webpage, https://www.federalreserve.gov/monetarypolicy/review-of-monetary-policy-strategy-tools-and-communications-fed-listens-timelines.htm; and Jerome H. Powell (2024), "Opening Remarks," speech delivered at the Stanford Business, Government, and Society Forum, Stanford Graduate School of Business, Stanford, Calif., April 3, https://www.federalreserve.gov/newsevents/speech/powell20240403a.htm. Return to text
8. In the past 15 years, information about the Committee's balance sheet policy has been an important part of the postmeeting statement and related FOMC statements. A detailed account of key communications on balance sheet policy that the Committee has issued in recent years is provided in Board of Governors of the Federal Reserve System (2024), "FOMC Communications Related to Policy Normalization," webpage, https://www.federalreserve.gov/monetarypolicy/policy-normalization.htm. A longer-term chronology, covering developments over the past decade, is available at Board of Governors of the Federal Reserve System (2024), "History of the FOMC's Policy Normalization Discussions and Communications," webpage, https://www.federalreserve.gov/monetarypolicy/policy-normalization-discussions-communications-history.htm. Return to text
...and has continued the process of significantly reducing its holdings of Treasury and agency securities
The FOMC began reducing its securities holdings in June 2022 and, since then, has continued to implement its plan for significantly reducing the size of the Federal Reserve's balance sheet in a predictable manner.9 For some time, principal payments from securities held in the System Open Market Account (SOMA) had been reinvested only to the extent that they exceeded monthly caps of $60 billion per month for Treasury securities and $35 billion per month for agency debt and agency mortgage-backed securities (MBS). On June 1, the Committee slowed the pace of decline of its securities holdings, consistent with its Plans for Reducing the Size of the Federal Reserve's Balance Sheet. Specifically, the Committee reduced the redemption cap on Treasury securities to $25 billion per month and maintained the redemption cap on agency debt and agency MBS at $35 billion per month. Any proceeds in excess of the agency debt and agency MBS cap would be reinvested into Treasury securities, consistent with the Committee's intention to hold primarily Treasury securities in the longer run. The decision to slow the pace of balance sheet runoff does not have implications for the stance of monetary policy and does not mean that the balance sheet will ultimately shrink by less than it would otherwise. Rather, a slower pace of balance sheet runoff helps facilitate a smooth transition from abundant to ample reserve balances and gives the Committee more time to assess market conditions as the balance sheet continues to shrink. It will also allow banks, and short-term funding markets more generally, additional time to adjust to the lower level of reserves, thus reducing the probability that money markets experience undue stress that could require an early end to runoff.
The SOMA holdings of Treasury and agency securities have declined about $1.7 trillion since the start of the balance sheet reduction and about $260 billion since February 2024 to around $6.8 trillion, a level equivalent to 24 percent of U.S. nominal gross domestic product, down from its peak of 35 percent reached at the end of 2021 (figure 47). Also, since February 2024, reserve balances—the largest liability item on the Federal Reserve's balance sheet—have declined about $180 billion to a level of around $3.4 trillion. The smaller decline of reserve balances compared with the decline in SOMA holdings reflects decreases in nonreserve liabilities such as balances at the overnight reverse repurchase agreement facility. (See the box "Developments in the Federal Reserve's Balance Sheet and Money Markets.")
The FOMC has stated that it intends to maintain securities holdings at amounts consistent with implementing monetary policy efficiently and effectively in its ample-reserves regime—that is, a regime in which an ample supply of reserves ensures that control over the level of the federal funds rate and other short-term interest rates is exercised primarily through the setting of the Federal Reserve's administered rates and in which active management of the supply of reserves is not required. To ensure a smooth transition to ample reserve balances, the FOMC slowed the pace of decline of its securities holdings in June 2024 and intends to stop reductions in its securities holdings when reserve balances are somewhat above the level that the FOMC judges to be consistent with ample reserves. Once balance sheet runoff has ceased, reserve balances will likely continue to decline at a slower pace—reflecting growth in other Federal Reserve liabilities—until the FOMC judges that reserve balances are at an ample level. Thereafter, the FOMC will manage securities holdings as needed to maintain ample reserves over time.
Developments in the Federal Reserve's Balance Sheet and Money Markets
The Federal Open Market Committee (FOMC) continued to reduce the size of the Federal Reserve's System Open Market Account (SOMA) portfolio. Since the previous report, total Federal Reserve assets have decreased $315 billion, leaving the total size of the balance sheet at $7.3 trillion, $1.7 trillion smaller since the reduction in the size of the SOMA portfolio began in June 2022 (figures A and B).1 On May 1, the FOMC announced that beginning in June, the Committee would slow the pace of decline of its securities holdings, consistent with its Plans for Reducing the Size of the Federal Reserve's Balance Sheet.2
A. Balance sheet comparison
Billions of dollars
| June 19, 2024 | February 28, 2024 | Change (since February 2024) | Memo: Change (since Fed's balance sheet reduction began on June 1, 2022) | |
|---|---|---|---|---|
| Assets | ||||
| Total securities | ||||
| Treasury securities | 4,453 | 4,661 | –208 | –1,318 |
| Agency debt and MBS | 2,357 | 2,406 | –49 | –353 |
| Unamortized premiums | 265 | 274 | –8 | –72 |
| Repurchase agreements | 0 | 0 | 0 | 0 |
| Loans and lending facilities | ||||
| PPPLF | 3 | 3 | 0 | –17 |
| Discount window | 7 | 2 | 5 | 6 |
| BTFP | 107 | 163 | –56 | 107 |
| Other loans and lending facilities | 11 | 15 | –4 | –23 |
| Central bank liquidity swaps | 0 | 0 | 0 | 0 |
| Other assets | 49 | 44 | 6 | 7 |
| Total assets | 7,253 | 7,568 | –315 | –1,663 |
| Liabilities | ||||
| Federal Reserve notes | 2,301 | 2,282 | 18 | 70 |
| Reserves held by depository institutions | 3,366 | 3,541 | –175 | 9 |
| Reverse repurchase agreements | ||||
| Foreign official and international accounts | 389 | 339 | 50 | 124 |
| Others | 376 | 570 | –194 | –1,589 |
| U.S. Treasury General Account | 782 | 768 | 14 | 2 |
| Other deposits | 158 | 162 | –4 | –90 |
| Other liabilities and capital | –120 | –94 | –25 | –188 |
| Total liabilities and capital | 7,253 | 7,568 | –315 | –1,663 |
Note: MBS is mortgage-backed securities. PPPLF is Paycheck Protection Program Liquidity Facility. BTFP is Bank Term Funding Program. Components may not sum to totals because of rounding.
Source: Federal Reserve Board, Statistical Release H.4.1, "Factors Affecting Reserve Balances"
Reserves, the largest liability item on the Federal Reserve's balance sheet, have declined $175 billion since late February 2024 to a level of about $3.4 trillion.3 Since the beginning of balance sheet runoff, reserves have been little changed because the reserve-draining effect of balance sheet runoff was more than offset by a $1.6 trillion decline in balances at the overnight reverse repurchase agreement (ON RRP) facility. Since February 2024, usage of the ON RRP facility has continued to decline, albeit at a slower pace than that seen over the second half of 2023. Usage of the facility has averaged around $450 billion since the end of February (figure C). Reduced usage of the ON RRP facility largely reflects money market mutual funds shifting their portfolios toward higher-yielding investments, including Treasury bills and private-market repurchase agreements.
Conditions in overnight money markets remained stable. The ON RRP facility continued to serve its intended purpose of supporting the control of the effective federal funds rate (EFFR), and the Federal Reserve's administered rates—the interest rate on reserve balances and the ON RRP offering rate—remained highly effective at maintaining the EFFR within the target range.
The Federal Reserve's expenses have continued to exceed its income over recent months. The Federal Reserve's deferred asset has increased $23 billion since late February to a level of around $175 billion.4 Negative net income and the associated deferred asset do not affect the Federal Reserve's conduct of monetary policy or its ability to meet its financial obligations.5
While the reduction in the size of the SOMA portfolio has continued as planned, amid the banking-sector developments of spring 2023, the Federal Reserve provided liquidity to help ensure the stability of the banking system and the ongoing provision of money and credit to the economy. Loans extended under the Bank Term Funding Program (BTFP)—which made longer-term funding and liquidity available to eligible depository institutions to support American households and businesses and ceased making new loans as scheduled on March 11, 2024—have decreased $56 billion to a level of $107 billion since February 2024.6
1. The last Federal Reserve Board statistical release H.4.1 ("Factors Affecting Reserve Balances") before the publication of the previous Monetary Policy Report on March 1 was dated February 29, 2024. As a result, this discussion refers to changes in the Federal Reserve's balance sheet since late February. Return to text
2. See the May 4, 2022, press release regarding the Plans for Reducing the Size of the Federal Reserve's Balance Sheet, available on the Board's website at https://www.federalreserve.gov/newsevents/pressreleases/monetary20220504b.htm. Return to text
3. Reserve balances consist of deposits held at the Federal Reserve Banks by depository institutions (DIs), such as commercial banks, savings banks, credit unions, thrift institutions, and U.S. branches and agencies of foreign banks. Return to text
4. The deferred asset is equal to the cumulative shortfall of net income and represents the amount of future net income that will need to be realized before remittances to the Treasury resume. Although remittances are suspended at the time of this report, over the past decade and a half, the Federal Reserve has remitted over $1 trillion to the Treasury. Return to text
5. Net income is expected to turn positive again as interest expenses fall, and remittances will resume once the temporary deferred asset falls to zero. As a result of the ongoing reduction in the size of the Federal Reserve's balance sheet, interest expenses will fall over time in line with the decline in the Federal Reserve's liabilities. Return to text
6. The BTFP was established under section 13(3) of the Federal Reserve Act with the approval of the Secretary of the Treasury. The BTFP offered loans of up to one year to banks, savings associations, credit unions, and other eligible DIs against collateral such as U.S. Treasury securities, U.S. agency securities, and U.S. agency mortgage-backed securities. For more details, see Board of Governors of the Federal Reserve System (2024), "Bank Term Funding Program," webpage, June 11, https://www.federalreserve.gov/financial-stability/bank-term-funding-program.htm. Return to text
The FOMC will continue to monitor the implications of incoming information for the economic outlook and the balance of risks
As already indicated, the FOMC is strongly committed to returning inflation to its 2 percent objective, and, in considering any adjustments to the target range for the federal funds rate, the Committee will carefully assess incoming data, the evolving outlook, and the balance of risks. Its assessments will take into account a wide range of information, including readings on labor market conditions, inflation pressures and inflation expectations, and financial and international developments. The Committee has noted that it is also prepared to adjust its approach to reducing the size of the balance sheet in light of economic and financial developments.
In addition to considering a wide range of economic and financial data, the FOMC gathers information from business contacts and other informed parties around the country, as summarized in the Beige Book. The Federal Reserve has regular arrangements under which it hears from a broad range of participants in the U.S. economy about how monetary policy affects people's daily lives and livelihoods. In particular, the Federal Reserve has continued to gather insights into these matters through the Fed Listens initiative and the Federal Reserve System's community development outreach.
Policymakers also routinely consult prescriptions for the policy interest rate provided by various monetary policy rules. These rule prescriptions can provide useful benchmarks for the conduct of monetary policy. However, simple rules cannot capture all of the complex considerations that go into the formation of appropriate monetary policy, and many practical considerations make it undesirable for the FOMC to adhere strictly to the prescriptions of any specific rule. Nevertheless, some principles of good monetary policy are embedded in these simple rules. (See the box "Monetary Policy Rules in the Current Environment.")
Monetary Policy Rules in the Current Environment
As part of their monetary policy deliberations, policymakers regularly consult the prescriptions of a variety of simple interest rate rules without mechanically following the prescriptions of any particular rule. Simple interest rate rules relate a policy interest rate, such as the federal funds rate, to a small number of other economic variables—typically including the current deviation of inflation from its target value and a measure of resource slack in the economy.
Since 2021, inflation has run above the Federal Open Market Committee's (FOMC) 2 percent longer-run objective, and labor market conditions have been tight. Although inflation remains elevated, it has eased over the past year, and labor supply and demand have come into better balance. Against this backdrop, the simple monetary policy rules considered in this discussion have called for levels of the policy interest rate over 2021, 2022, and the first half of 2023 that were elevated relative to the FOMC's target range for the federal funds rate. However, the rates prescribed by these rules for the first quarter of 2024, the most recent quarter for which data are available, are close to or below the current target range for the federal funds rate at 5-1/4 to 5-1/2 percent. In support of its goals of maximum employment and inflation at the rate of 2 percent over the longer run, the FOMC has maintained the target range for the federal funds rate at 5-1/4 to 5-1/2 percent since last July while continuing to reduce its holdings of Treasury securities and agency debt and agency mortgage-backed securities.
Selected Policy Rules: Descriptions
In many economic models, desirable economic outcomes can be achieved over time if monetary policy responds to changes in economic conditions in a manner that is predictable and adheres to some key design principles. In recognition of this idea, economists have analyzed many monetary policy rules, including the well-known Taylor (1993) rule, the "balanced approach" rule, the "adjusted Taylor (1993)" rule, and the "first difference" rule.1 Figure A shows these rules, along with a "balanced approach (shortfalls)" rule, which responds to the unemployment rate only when it is higher than its estimated longer-run level.2 All of the simple rules shown embody key design principles of good monetary policy, including the requirement that the policy rate should be adjusted by enough over time to ensure a return of inflation to the central bank's longer-run objective and to anchor longer-term inflation expectations at levels consistent with that objective.
All five rules feature the difference between inflation and the FOMC's longer-run objective of 2 percent. The five rules use the unemployment rate gap, measured as the difference between an estimate of the rate of unemployment in the longer run ($$ u_t^{LR}$$) and the current unemployment rate; the first-difference rule includes the change in the unemployment rate gap rather than its level.3 All but the first-difference rule include an estimate of the neutral real interest rate in the longer run ($$ r_t^{LR}$$).4
Unlike the other simple rules featured here, the adjusted Taylor (1993) rule recognizes that the federal funds rate cannot be reduced materially below the effective lower bound (ELB). By contrast, the standard Taylor (1993) rule prescribed policy rates that, during the pandemic-induced recession, were far below zero. To make up for the cumulative shortfall in policy accommodation following a recession during which the federal funds rate is constrained by its ELB, the adjusted Taylor (1993) rule prescribes delaying the return of the policy rate to the (positive) levels prescribed by the standard Taylor (1993) rule.
Policy Rules: Limitations
As benchmarks for monetary policy, simple policy rules have important limitations. One of these limitations is that the simple policy rules mechanically respond to only a small set of economic variables and thus necessarily abstract from many of the factors that the FOMC considers when it assesses the appropriate setting of the policy rate. In addition, the structure of the economy and current economic conditions differ in important respects from those prevailing when the simple policy rules were originally devised and proposed. As a result, most simple policy rules do not take into account the ELB on interest rates, which limits the extent to which the policy rate can be lowered to support the economy. This constraint was particularly evident during the pandemic-driven recession, when the lower bound on the policy rate motivated the FOMC's other policy actions to support the economy. Relatedly, another limitation is that simple policy rules do not explicitly take into account other important tools of monetary policy, such as balance sheet policies. Finally, simple policy rules are not forward looking and do not allow for important risk-management considerations, associated with uncertainty about economic relationships and the evolution of the economy, that factor into FOMC decisions.
Selected Policy Rules: Prescriptions
Figure B shows historical prescriptions for the federal funds rate under the five simple rules considered. For each quarterly period, the figure reports the policy rates prescribed by the rules, taking as given the prevailing economic conditions and survey-based estimates of $$ u_t^{LR}$$ and $$ r_t^{LR}$$ at the time. All of the rules considered called for a highly accommodative stance of monetary policy in response to the pandemic-driven recession, followed by positive values as inflation picked up and labor market conditions strengthened.5 In 2022 and during the first half of 2023, the prescriptions of the simple rules for the federal funds rate were well above the prescriptions observed before the pandemic, reflecting, in large part, elevated inflation readings. Because inflation has recently run notably below levels observed at its peak in 2022, the policy rates prescribed by these rules have now declined. The current prescriptions from these rules are close to or below the current target range for the federal funds rate, though higher than survey-based estimates of the longer-run value of the federal funds rate.
1. The Taylor (1993) rule was introduced in John B. Taylor (1993), "Discretion versus Policy Rules in Practice," Carnegie-Rochester Conference Series on Public Policy, vol. 39 (December), pp. 195–214. The balanced-approach rule was analyzed in John B. Taylor (1999), "A Historical Analysis of Monetary Policy Rules," in John B. Taylor, ed., Monetary Policy Rules (Chicago: University of Chicago Press), pp. 319–41. The adjusted Taylor (1993) rule was studied in David Reifschneider and John C. Williams (2000), "Three Lessons for Monetary Policy in a Low-Inflation Era," Journal of Money, Credit and Banking, vol. 32 (November), pp. 936–66. The first-difference rule is based on a rule suggested by Athanasios Orphanides (2003), "Historical Monetary Policy Analysis and the Taylor Rule," Journal of Monetary Economics, vol. 50 (July), pp. 983–1022. A review of policy rules is provided in John B. Taylor and John C. Williams (2011), "Simple and Robust Rules for Monetary Policy," in Benjamin M. Friedman and Michael Woodford, eds., Handbook of Monetary Economics, vol. 3B (Amsterdam: North-Holland), pp. 829–59. The same volume of the Handbook of Monetary Economics also discusses approaches to deriving policy rate prescriptions other than through the use of simple rules. Return to text
2. The balanced-approach (shortfalls) rule responds asymmetrically to unemployment rates above or below their estimated longer-run value: When unemployment is above that value, the policy rates are identical to those prescribed by the balanced-approach rule, whereas when unemployment is below that value, policy rates do not rise because of further declines in the unemployment rate. As a result, the prescription of the balanced-approach (shortfalls) rule has been less restrictive than that of the balanced-approach rule since the first quarter of 2022. Return to text
3. Implementations of simple rules often use the output gap as a measure of resource slack in the economy. The rules described in figure A instead use the unemployment rate gap because that gap better captures the FOMC's statutory goal to promote maximum employment. Movements in these alternative measures of resource utilization tend to be highly correlated. For more information, see the note associated with figure A. Return to text
4. The neutral real interest rate in the longer run ($$ r_t^{LR}$$) is the level of the real federal funds rate that is expected to be consistent, in the longer run, with maximum employment and stable inflation. Like $$ u_t^{LR}$$, $$ r_t^{LR}$$ is determined largely by nonmonetary factors. The first-difference rule shown in figure A does not require an estimate of $$ r_t^{LR}$$, a feature that is touted by proponents of such rules as providing an element of robustness. However, this rule has its own shortcomings. For example, research suggests that this sort of rule often results in greater volatility in employment and inflation than what would be obtained under the Taylor (1993) and balanced-approach rules. Return to text
5. For the adjusted Taylor (1993) rule, $$ z_t$$—the cumulative sum of past deviations of the federal funds rate from the prescriptions of the Taylor (1993) rule when that rule prescribes setting the federal funds rate below an ELB of 12.5 basis points—is positive in the third quarter of 2020, one quarter after the prescription of the Taylor (1993) rule falls below the ELB, through to the first quarter of 2022. This approach is a slight adjustment from previous editions of this discussion in the Monetary Policy Report, where $$ z_t$$ cumulated from the fourth quarter of 2020. Return to text
Footnotes
9. See the May 4, 2022, press release regarding the Plans for Reducing the Size of the Federal Reserve's Balance Sheet, available on the Board's website at https://www.federalreserve.gov/newsevents/pressreleases/monetary20220504b.htm. Return to text