It sneaks up on you. Worrying about the Federal Reserve is the last thing on your mind, but then the press and pundits seem obsessed with “tightening” and “dot plots,” making it increasingly urgent—but not any easier—to understand what this means for you.
Yes, the Federal Reserve does have an impact on your life, especially when the economy is in transition, like now. The nation’s central bank influences how much it costs to borrow money on a credit card or through a mortgage and even how much you pay for groceries and gas. In fact, the two are very connected, which is why borrowing costs are on the rise now.
If you’re trying to follow it all, you’re likely to hear a lot of terms bandied about. Here’s how to translate the jargon.
FOMC is an acronym for the Federal Open Market Committee, the part of the Federal Reserve that decides the target range for the benchmark interest rate (see fed funds rate below) and, in essence, how much money will be available for people and businesses to borrow. The FOMC considers the prospects for U.S. economic growth and the unemployment and inflation rates when making these decisions.
The committee generally meets eight times a year, but can also call emergency meetings when necessary. There are 12 members on the committee: the seven members of the Federal Reserve’s Board of Governors, plus the president of the Federal Reserve Bank of New York and four of the remaining 11 Reserve Bank presidents.
Monetary policy refers to the decisions taken by a central bank like the Fed to control and influence the money supply, or amount and cost of credit in an economy. The Fed has several tools to do this, but the most commonly used and well-known ones involve setting the target for the benchmark fed funds rate (see below) and buying and selling U.S. government securities on the open market.
Fed Funds Rate
The federal funds rate is the interest rate banks use to lend and borrow funds from one another. The funds come out of the cash reserves banks keep on hand. Every time the FOMC meets, it decides whether to change the target range for this benchmark, which influences a host of other interest rates, including those on auto loans, mortgages, and credit cards. A higher target rate is set to curb inflation and slow economic growth, while a lower rate is meant to spur activity.
The target rate had been nearly zero since March 2020, but in order to fight soaring inflation, the Fed pivoted on March 16, raising the fed funds rate for the first time in years and announcing several more increases would be coming this year and next. The central bank raised the rate again on May 4, by twice as much.
While the low benchmark was intended to encourage borrowing and spending at a time when people were losing their jobs, the Fed has the opposite goal now. Much of the economy has recovered, and there aren’t enough of many goods and services to meet demand, with shortages of supplies and workers fueling inflation.
Target Inflation Rate
One of the Fed’s jobs is to manage inflation—how much consumer prices rise, broadly speaking. Think of it like Goldilocks. The Fed wants inflation, like her porridge, not too hot and not too cold.
The target inflation rate is the Fed’s goal for inflation. Depending on how far off actual inflation rates are, the Fed judges whether to use its tools to heat it up, cool it down, or do nothing. Since 2012, the Fed has explicitly stated the target rate is 2%, though in 2020, when the pandemic had cooled inflation dramatically, policymakers said they would strive for inflation “moderately above” 2% for a while. In essence, they wanted to even things out and get us back to averaging 2% over time. This year, however, the Fed’s preferred measure of inflation has soared to 6.6% (5.2% excluding food and energy prices.)
Like an airplane, you want a “soft landing”—not a crash—for the economy if you’re trying to deliberately slow it down. That’s why the term is often used to describe the Fed’s goal for slowing down the economy to tamp down inflation.
By raising borrowing costs, the Fed will discourage spending and rein in the sharp increases in consumer prices. But Fed officials must not overdo it, slowing the economy so much that it slips into a recession. That would be a very hard landing.
It’s a delicate balancing act, and one that Fed Chair Jerome Powell has acknowledged is not going to be easy. Fed officials believe the economy is strong enough that it can be brought in for a soft landing, but some economists think the odds are against it.
Quantitative easing, sometimes just called “QE” for short, is another tool the Fed can use to spur economic growth. The Fed buys assets—usually long-maturity government debt, but sometimes corporate bonds or asset-backed securities—on a large scale as a way of expanding the money supply and stimulating the economy. This is a fairly new, unconventional tactic used when even setting the benchmark interest rate at nearly zero hasn’t done enough to recover the economy. In essence, when all else fails.
The Fed started buying bonds at the beginning of the pandemic to keep money flowing through the economy, but with inflation running hot throughout much of 2021 and 2022 the Fed reduced and then ended its asset purchases as a way to cool things down. This type of reduction in quantitative easing is known as tapering (see below).
(The Fed first used quantitative easing over a decade ago, following the great financial crisis. It’s controversial, though, since it’s not always clear how effective it is or whether it has unintended negative consequences on the financial markets.)
Tightening is when the Fed raises the fed funds target rate or makes other moves to drain money from the economy, usually to control inflation. When money flows out of the system, it dampens consumer spending and investment, slowing the economy and keeping prices in check. The opposite of this tightening (also called contractionary or restrictive monetary policy), is called easing or loosening. This is when the Fed uses its tools to add money to the system, pushing interest rates lower and increasing demand (because it’s cheaper to borrow money).
The dot plot is a chart, or visual guide, breaking out what individual FOMC members expect the fed funds rate to be over the course of the next few years. Released quarterly, it’s like a map of their expectations. Each dot represents the view of one FOMC member. The press and economists often focus on the median number derived from all forecasts.
Tapering refers to a gradual slowing of the pace of those large-scale purchases made as part of quantitative easing—essentially a reversal of these special tactics.
“Taper tantrum” refers to the reaction of the bond market to then-Fed Chair Ben Bernanke’s announcement in 2013 that the central bank would begin tapering its asset purchases at some future date. The announcement caused a shock to financial markets, and investors began aggressively selling their bonds, causing the yield on 10-year Treasuries to rise sharply. The market reaction to the Fed’s announcement to taper was dubbed a “tantrum.”
Maximum employment is one of the Fed’s goals, though unlike the target inflation rate, there isn’t a number assigned to it, and it’s up to the Fed to decide how close the economy is to this goal. You might say, though (and the San Francisco Federal Reserve Bank’s online resources do say this) that intuitively, when the economy is at maximum employment, anyone who wants a job can get one.
This story was originally published on Nov. 3, 2021.