The Retirement Corporation of America

Understanding Monetary Policy

FISCAL POLICY IS set out in public—out on the floor of Congress for all to see. Each fiscal policy decision made by Congress will be felt very quickly by all of us. Monetary policy is made in private by officials of the Federal Reserve. It works on the economy in a more indirect way and takes more time for its impact to be felt.

The Federal Reserve was created back in 1907 after the country suffered through one of the worst economic episodes in history—the Panic of 1907. Stock prices crashed, banks failed and the economy stumbled into deep recession. Congress decided it needed some institution to help stabilize the economy. The Federal Reserve was its choice. Their mission was to:

•  Regulate the supply of money in the economy—making sure there was always just enough to finance reasonable economic growth. Too little money and the economy can literally die of starvation—plunging into recession. Too much money and the resultant spending spree could send the economy into inflationary orbit. Their job is to play Goldilocks—keeping the money supply just right.

•  Regulate the cost of money in the economy—making sure that interest rates were set at just the right level to keep the economy growing at just the right speed. If rates are too high, people won't borrow to build homes or buy cars and create new businesses, and the economy will slow to a crawl. If rates are too low, people will borrow up a storm, and that could help trigger inflation. Here, too, the Fed's job is to keep the level of interest rates just right.

Exactly how it carries out those chores gets pretty complex and is much more information than you really need to know to master your own financial future. First, let's look at the Federal Reserve itself. Just understand what it can do and why what it does matters a lot to you. Headquarters of the federal government is in Washington where the chairman of the Federal Reserve Board and the six Federal Reserve governors are. Board members are picked for 14-year terms and one of its seven governors is picked to serve a four-year term as chairman. Beyond the headquarters in Washington, there are 12 regional Federal Reserve banks (Boston, New York, Philadelphia, Richmond, Atlanta, Cleveland, Chicago, St. Louis, Kansas City, Dallas, Minneapolis, and San Francisco), each run by its own president.

The Federal Reserve is an independent agency, meaning that it operates independently of the day-to-day control of either the president or Congress. The president picks the governors and the chairman and Congress has to approve his choices. Beyond that, the Fed is free to go its own way, making its own decisions about the money supply and interest rates. That independence is to make certain that a president—in the heat of an election campaign—doesn't order them to create enough new money so everybody gets an extra million dollars. Since too much money can be inflationary, that wouldn't be a very good idea. By creating the Federal Reserve as an independent agency, it was kept out from under the direct control of politicians running for re-election.

Following the Federal Reserve

The main policy-setting body of the Federal Reserve is the Federal Open Market Committee (FOMC)—comprised of the chairman, the other six Federal Reserve governors and the presidents of the 12 regional Federal Reserve Banks. The FOMC meets periodically in Washington to set monetary policy for the next month or so. It could:

•  Decide to slow down the economy by tightening monetary policy—reducing the supply of money and pushing up interest rates. It would do that if it felt inflation was a danger.

•  Decide to speed up the economy by easing monetary policy—increasing the supply of money and pushing down interest rates. It would do that if it felt the economy was running too slowly.

•  Leave monetary policy unchanged—not changing the supply of money and not changing interest rates. It would do that if it felt the economy was doing just fine.
he Fed has a few other options up its sleeve:

•  It can keep the policy unchanged but indicate that its current "bias" is toward fighting inflation.

•  It can keep the policy unchanged but indicate that its current "bias" is toward strengthening the economy.

•  It can keep the policy neutral.

Monetary policy is a powerful weapon. When the Fed decides to speed up the economy, it is setting the stage for fatter paychecks and fatter corporate profits. Both are very favorable to the stock market. When it decides to slow down the economy, it is setting the stage for leaner paychecks and leaner corporate profits. Both are highly negative for the stock market.

Small wonder that everything the Fed does is watched closely by investors. There are endless debates about what might happen before each Federal Open Market Committee meeting. Markets come to a near stop during the meeting. Results of the meeting are announced as soon as it ends and what is announced can send the market sharply higher or sharply lower or result in no real change at all.

Federal chairmen are very influential people. They are called upon to testify before Congress frequently. What the chairman says at such a Congressional appearance can also influence the investment markets.

Keeping Tabs on Monetary Policy

As noted, monetary policy is considered crucial to the economic outlook, so keeping track of monetary policy and explaining it to the world has become a big growth industry.

The media is filled with stories and speculation before, during and after a Federal Open Market Committee meeting. Ditto for each Congressional or public appearance by the chairman. Each and every detail is covered in newspapers, on radio, TV and the Internet. Financial cable networks, such as CNBC and CNNfn will cover each Federal Reserve meeting and appearance by a Fed chairman in mind-numbing detail.

Brokerage houses, banks and mutual funds hire economists whose sole job is to interpret and explain the Federal Reserve to the world at large. The various financial publications will cover the Fed and monetary policy as well.

As with so much else about the economy, you won't have to hunt down details about monetary policy. They will invariably find you.