Definition: Monetary policy is what a central bank does to influence interest rates and the amount of money and credit in the economy, with the aim of keeping inflation low and stable and supporting jobs and growth.
Explanation
Goals. Each central bank has a mandate set by law:
- The US Federal Reserve has a dual mandate: maximum employment and stable prices.
- The European Central Bank and the Bank of England focus on price stability, with an inflation target of 2%.
Main tools.
- The policy interest rate, for example the federal funds target range in the US or Bank Rate in the UK.
- Open Market Transactions: buying and selling bonds to manage the amount of reserves in the banking system.
- Interest on reserves: the rate the central bank pays banks on the money they keep with it.
- Forward guidance: telling markets what the central bank expects to do next.
- The balance sheet: large bond purchases (quantitative easing, QE) or letting bonds mature without replacing them (quantitative tightening, QT).
Loose or tight.
- Expansionary (loose) policy cuts rates or buys assets to encourage borrowing and spending.
- Contractionary (tight) policy raises rates or shrinks the balance sheet to cool demand and bring inflation down.
How it reaches the economy. A rate change moves other borrowing costs (mortgages, business loans, bond yields), asset prices and the exchange rate. These change how much people and businesses spend, which then affects inflation. The full effect takes many months.
Examples
- March 2020: the Fed cut its target range to 0 to 0.25% as the pandemic hit.
- March 2022 to July 2023: the Fed raised its target range from 0 to 0.25% up to 5.25 to 5.50% to fight high inflation.
- July 2022: the European Central Bank raised rates for the first time in eleven years.