The Federal Reserve Act instructs the Federal Reserve to use monetary policy to promote maximum employment, stable prices, and moderate long-term interest rates. In practice, the Fed “leads against the economic wind,” tightening policy when inflation threatens the economy and easing policy when the economy weakens. This article explains one way to measure monetary policy stance; that is, how to measure the configuration of the Fed’s instruments in light of the economic wind.
Measuring the monetary policy setting
Since 2008, the Fed has conducted monetary policy using both conventional and unconventional tools. Short-term interest rate management is the Fed’s key conventional tool, while longer-term bond buying and forward guidance have been its main unconventional tools.
When the Federal Reserve is implementing conventional policy, analysts often use the level of short-term interest rates to gauge (crudely) the policy stance. High short-term interest rates tend to slow down economic activity, while low short-term interest rates tend to do the opposite.
While short-term interest rates controlled by the Federal Reserve continue to serve as an important measure of monetary policy, prolonged periods at the effective lower bound of interest rates, combined with new monetary policy tools, mean that we need a summary measure of monetary policy mix. adjustments to gauge policy stance.
One such monetary policy measure is the “shadow” federal funds rate. Based on a many-maturity interest rate model, the shadow rate is an estimate of what the Fed’s overnight interest rate would be if the FOMC extended its policy range below zero, which it currently does not. This captures how the Federal Reserve’s interest rate tools, including large-scale asset purchases and forward guidance, affect the current and expected future trajectory of the federal funds rate.
However, the neutral level of the federal funds rate, one that cannot be characterized as tight or flexible, changes over time. Thus, whether a certain level of interest rates stimulates or contracts economic activity depends on its relation to this moving target.
One approach to estimating the long-term neutral rate is to look for an indicator in financial markets that suggests what the short-term rate will be in the distant future, after any current economic storm has passed. A Treasury long-term interest rate is just such an indicator: it is related to the short-term interest rate that is expected to prevail on a particular date in the future, derived from current market prices.
Therefore, comparing the federal funds rate or a shadow federal funds rate to a long-term Treasury forward rate allows us to characterize the degree of tightening or easing that the Federal Reserve is applying to the economy if it is assumed that the Current conditions are average or normal. But of course, current conditions may not be average, as explored in the next section. The figure below shows how this measure of the Fed’s monetary policy setting has varied each month between December 1971 and December 2021.
A measure of monetary policy settings: fed funds or shadow rate minus neutral rate
SOURCES: Federal Reserve Board, Federal Reserve Bank of Atlanta, and author’s calculations.
NOTES: The figure shows a monthly measure of the Fed’s monetary policy setting between December 1971 and December 2021. The line shows the difference between the federal funds rate, when the lower bound of the Fed’s target range is above zero, and the 15-year interest rate. Treasury forward rate, which serves as a proxy for the neutral rate. The shadow federal funds rate is replaced by the federal funds rate when the lower end of the federal funds target range equals zero. In the figure, upward movements indicate monetary policy tightening, while downward movements indicate policy easing. A tighter policy is expected to slow the economy, while a looser policy is expected to strengthen the economy.
Measuring the Strength of the Economy
The impact of monetary policy on the economy depends both on how tight or easy the Fed policy setting is at any given time (as shown in the figure above) Y about the state of the economy. If the economy is very weak, for example, with an unemployment rate in double digits, then accommodative monetary policy is likely to be appropriate, with the federal funds (or shadow) rate well below the neutral rate. The Fed’s leaning against the wind policy attempts to counter the weakness in the economy. If the economy is very strong, for example, with very low unemployment and rising inflation, the Federal Reserve is likely to set the federal funds rate closer to or even above the neutral rate.
The following figure compares the summary measure of Fed policy described above with the output gap, that is, the strength of the economy. The Fed’s monetary policy settings follow the state of the economy. When the output gap is positive, which is near the peaks of the business cycle, the Federal Reserve runs a tighter monetary policy. Conversely, when the output gap is negative, when the economy is in or recovering from a recession, the Federal Reserve sets monetary policy looser. Again, this is how the Federal Reserve leans against the economic wind: the central bank exercises restraint when the economy is very strong and provides support when it is very weak.
A measure of the monetary policy setting and the economy’s output gap
SOURCES: Federal Reserve Board, Federal Reserve Bank of Atlanta, Congressional Budget Office, and author’s calculations.
NOTES: The figure shows a quarterly measure of the Federal Reserve’s monetary policy setting between the first quarter of 1972 and the fourth quarter of 2021 and the CBO estimate of the economy’s output gap between the first quarter of 1970 and Q4 2021, along with CBO Projections for the next decade. The measure of the Fed’s monetary policy setting is explained in the notes to the first chart. The output gap is the percentage difference between actual real GDP and the CBO estimate of potential real GDP.
Combining Fed Instrument Setup and Economic Windspeed: The Monetary Policy Stance
The figure below characterizes the Federal Reserve’s monetary policy stance since early 1972. The line represents the difference between the monetary policy setting and the economy’s output gap on a quarterly basis. For example:
- When the stance is zero, monetary policy roughly offsets the strength or weakness of the economy.
- When the stance is positive, monetary policy is restrictive or tight, and the degree of tightening exceeds the strength of the economy.
- When the stance is negative, monetary policy is accommodative or easy, and the degree of ease outweighs the weakness of the economy.
The monetary policy stance: the configuration of the Fed’s instruments in relation to economic conditions
SOURCES: See figures above for data sources.
NOTES: The graph shows the quarterly difference between the measure of the monetary policy setting described in the text and the economy’s output gap between the first quarter of 1972 and the fourth quarter of 2021. The line represents the position of the monetary policy, which combines the setting of monetary policy and the strength of the economy. Moves up in the figure represent a tighter policy stance, while moves down represent a looser policy stance.
Monetary policy stance has fluctuated significantly during the pandemic
According to the measure in the graph, the most restrictive monetary policy stance in the last 50 years occurred in the second quarter of 2020, when the COVID-19 crisis had its maximum impact. The economy was very weak, with real GDP 10.5% below its potential. Although the Fed aggressively eased monetary policy using several of its tools, it was not enough to offset the weakness in the economy.
By contrast, one of the most accommodative monetary policy stances since 1972 occurred in the fourth quarter of 2021. According to the Congressional Budget Office estimate, the economy had fully recovered by the third quarter of 2021 and was 1.4% above its potential in the fourth quarter of that year. Meanwhile, monetary policy settings remained relatively easy.
The COVID-19 period illustrates how important it is to gauge both the Fed’s monetary policy setting Y the current condition of the economy to gauge the stance of monetary policy. Although the Fed did not change its target range for the federal funds rate between mid-March 2020 and mid-March 2022, the ultimate impact of monetary policy on the economy fluctuated dramatically. Therefore, it is important to measure monetary policy against the strength of the economy and adjust accordingly.
- Watch Section 2A“Monetary Policy Objectives,” in the Federal Reserve Act.
- Watch “policy tools.”
- Watch “Principles and Practice of Monetary Policy.”
- The lower bound of the federal funds rate target range was zero between December 16, 2008, and December 16, 2015, and again between March 16, 2020, and March 16, 2022.
- See Jing Cynthia Wu and Fan Dora Xia, “Measuring the Macroeconomic Impact of Monetary Policy at the Zero Lower Bound,” Money, Credit and Banking Magazine, vol. 48, Nos. 2-3, March-April 2016. See Atlanta Federal Reserve for more explanation and current shadow rate.
- See Michael D. Bauer and Glenn D. Rudebusch, “Interest Rates Under Falling Stars,” American Economic Review, vol. 110, No. 5, May 2020.
- The output gap is the difference, in percentage, between the current real output level and the current hypothetical level of full employment. See the section “Budget and Economic Data” on the Congressional Budget Office website for an explanation of potential real GDP and the output gap.
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