Other Money + The Market Topics:

Monetary Policy

The Issue

Monetary policy entails an attempt to control the money supply (the amount of money in an economy) to achieve some predetermined economic outcome such as controlling inflation. Rather than allowing private markets to figure out how much money is needed, the U.S. relies on a central bank, the Federal Reserve, to determine what the correct money supply should be. Since the 1930s, the Fed has enjoyed a monopoly on the type of money issued in the U.S. rather than allowing competing currencies. The Fed uses its monopoly to plan the monetary sector of the economy, but it faces the same problems as any other central authority that tries to control economic activity. In particular, it is impossible for any planner to gather all of the information required to account for individual market participants’ wants, needs, and intentions, and the central authority faces no economic repercussions when it makes mistakes.

The Fed regularly manipulates the money supply in an attempt to promote both stable prices and high employment, but it is not accountable for failing to hit any specific economic targets. At its own discretion, the Fed buys Treasury securities in the open market to speed up the economy and sells them to slow down the economy. After six consecutive years of the Fed’s aggressive expansionary monetary policy, policymakers should start to question the effectiveness of this policy. These distortionary policies, rather than expanding the economy, have harmed its long-term health.

By injecting so much money into the system through purchases of Treasury securities, the Fed has helped keep short-term interest rates lower than they otherwise would be. People who prefer traditionally safe investments, such as certificates of deposit (CDs), have suffered because CD rates have been artificially suppressed. Similarly, low short-term money market rates have almost surely caused some people to forgo saving and others to choose higher-return investments.

To the extent that people decided against saving, choosing instead to spend more or hold cash, future economic growth will be harmed because fewer funds will be available for investments in physical goods such as homes, factories, and buildings. To the degree that individuals shifted savings into riskier investments, such as the stock market, those assets have become priced higher than they otherwise would be (possibly leading to the next financial “bubble” that will burst). Allowing market participants to respond on their own rather than imposing the Fed’s wishes would mitigate these problems by not artificially distorting interest rates.

Since the 2008 financial crisis, the Fed has also expanded its role in fiscal and regulatory policies. For instance, the Fed’s quantitative easing (QE) programs have purchased trillions of dollars of mortgage-backed securities (MBS) and debt of the insolvent government-sponsored enterprises Fannie Mae and Freddie Mac, a decision that leaves taxpayers responsible for the assets that led to the financial crisis. Through the Dodd–Frank bill, the Fed now has enormous regulatory power over even non-bank financial firms. The Fed now has a large say in whether these firms are designated for special “enhanced” regulations and also has the ability to apply specific rules and regulations to the designated firms on a case-by-case basis, thus adding to uncertainty in the private markets.


Start Selling Long-Term Government Bonds and GSE Obligations. The Fed continued its quantitative easing programs for far too long. In the short term, Congress should require the Fed to announce a plan detailing how it will normalize its balance sheet and get rid of the government-sponsored enterprise securities it bought.

Repeal Dodd–Frank. The 2010 Dodd–Frank Wall Street Reform and Consumer Protection Act increased regulations on virtually every aspect of the financial sector and even broadened the government’s reach into the non-bank sector. For instance, Title I of Dodd–Frank empowers the Federal Reserve and the U.S. Treasury, through the Financial Stability Oversight Council (FSOC), to determine which non-bank financial companies fall under new bank-like regulations. Specifically, Title I requires the Federal Reserve to regulate large banks more stringently than it did before the financial crisis and to regulate the FSOC-designated non-bank financial companies as if they were large banks. The central bank of the U.S. should not be involved in regulating banks, much less the non-banking sector of the economy; doing so only extends the type of government bailouts that have left taxpayers responsible for saving failed companies. Short of a full repeal of Dodd–Frank, Congress’s next best option would be to repeal Title I of Dodd–Frank.

Review Fed Performance with a Formal Commission. Congress should review the effectiveness of the Federal Reserve with a formal commission, such as the one proposed by Representative Kevin Brady (R–TX) in the Centennial Monetary Commission Act of 2015 (H.R. 2912) or Senator John Cornyn’s (R–TX) S. 1786. Brady’s bill, for example, would “establish a commission to examine the United States monetary policy, evaluate alternative monetary regimes, and recommend a course for monetary policy going forward.” The Fed will not be reformed easily, and a national commission much like the one that was required to start the Federal Reserve system in the first place could be the best way for Congress to begin to improve America’s monetary policy.

Implement Rules-Based Policies. Congress should end the Fed’s discretionary monetary policy and direct the central bank to implement rules-based policies that move the U.S. toward a truly competitive monetary system. Currently, the Fed conducts its monetary policies as if inducing a bit more inflation will increase employment, despite economists’ consensus, in the words of Frederic S. Mishkin, that “there is no long-run tradeoff between output (employment) and inflation” (Monetary Policy Strategy, 2009). The most damaging aspect of what the Fed does to the economy is that it conducts discretionary monetary policy devoid of any rules, thus distorting private markets.

Facts and Figures

  • Certificate of deposit rates dropped from just under 5 percent at the end of 2007 to less than 1 percent by 2009 and approximately 0.2 percent as of October 2015. As long as banks have so much money (excess reserves) to use for making new loans, they will not need to offer high CD rates to attract more funds.
  • The Federal Reserve has created more than $2 trillion in excess reserves since the financial crisis, whereas the highest month-ending amount in the banking system between 1959 and 2007 was only $19 billion. Additionally, the Fed now holds more than $3 trillion in long-term Treasuries and mortgage-backed securities that led to the financial crisis.
  • One financial consulting firm estimates that the Fed stands to lose between $200 billion and $550 billion on these MBS in the next three years, depending on how much (and how soon) interest rates rise. A private bank with this sort of balance sheet would likely become insolvent as interest rates increased.
  • The Fed’s post-crisis bond-buying programs have given banks an additional $2 trillion in excess reserves, which means they can create up to $20 trillion in new money. When banks find it more profitable to lend than hold these excess reserves, they will have the power to nearly double the amount of money in the U.S. economy, greatly increasing the danger of inflation.

Selected Additional Resources

Norbert J. Michel, “The Centennial Monetary Commission Act of 2013: A Second Look at the Fed and the 2008 Financial Crisis,” Heritage Foundation Backgrounder No. 2926, July 1, 2014.

Norbert J. Michel, “Dodd–Frank’s Title XI Does Not End Federal Reserve Bailouts,” Heritage Foundation Backgrounder No. 3060, September 29, 2015.

Norbert J. Michel, “The Fed at 100: A Primer on Monetary Policy,” Heritage Foundation Backgrounder No. 2876, January 29, 2014.

Norbert J. Michel, “The Fed at 100: Why Do We Have a Central Bank?” Heritage Foundation, The Daily Signal, December 19, 2013.

Norbert J. Michel, “Federal Reserve Performance: Have Business Cycles Really Been Tamed?” Heritage Foundation Backgrounder No. 2965, October 24, 2014.

Norbert J. Michel, “Federal Reserve Performance: What Is the Fed’s Track Record on Inflation?” Heritage Foundation Backgrounder No. 2968, October 27, 2014.

Norbert J. Michel, “Federal Reserve’s Expansion of Repurchase Market Is a Bad Idea,” Heritage Foundation Issue Brief No. 4261, August 14, 2014.

Norbert J. Michel, “The Fed’s Failure as a Lender of Last Resort: What to Do About It,” Heritage Foundation Backgrounder No. 2943, August 20, 2014.

Norbert J. Michel, “Improving Financial Institution Supervision: Ending the Federal Reserve’s Regulatory Role,” December 3, 2014, testimony before the Financial Institutions and Consumer Protection Subcommittee, Committee on Banking, Housing and Urban Affairs, U.S. Senate.

Norbert J. Michel, “Why Congress Should Institute Rules-Based Monetary Policy,” Heritage Foundation Backgrounder No. 2991, February 11, 2015.

Norbert J. Michel and Gerald P. Dwyer, “Bits and Pieces: The Digital World of Bitcoin Currency,” Heritage Foundation Backgrounder No. 3047, September 16, 2015.

Norbert J. Michel and Stephen Moore, “Quantitative Easing, The Fed’s Balance Sheet, and Central Bank Insolvency,” Heritage Foundation Backgrounder No. 2938, August 14, 2014.