Handbook of Finance: Financial Markets and Instruments

Chapter 4. Monetary Policy: How the Fed Sets, Implements, and Measures Policy Choices

DAVID M. JONES, PhD

President, DMJ Advisors, LLC

ELLEN J. RACHLIN

Managing Director, Portfolio Management, Mariner Investment Group, Inc.

Abstract: The Federal Reserve's twin goals are to achieve sustainable economic growth and stable prices. The Federal Reserve strives also to contain inflationary expectations. The Fed seeks to influence the U.S. economy in a manner which allows it to grow at a pace which will employ all available resources but not so fast a pace as to fuel inflation. The Federal Reserve's effectiveness in achieving the dual goals of price stability and sustainable economic growth is limited to their direct influence on short-term interest rates and indirect effect on long-term interest rates. Historically, the Federal Reserve under different chairmen has favored targeting the Federal funds rate most of the time. The Federal Reserve is challenged in achieving the desired results due to its indirect influence over global capital flows. At times, global capital flows may work against what the Federal Reserve is trying to achieve. An investor who can anticipate Federal Reserve policy shifts can more accurately anticipate changes in asset valuations. The Federal Reserve, in setting short-term interest rates, ultimately affects asset repricings and valuations. An investor needs to understand the dynamics of Federal Reserve policy shifts and pay attention to key economic indicators that ...