What Monetary Policy Can and Can’t Do

Monetary policy determines the long-run path of the price level and that has remained essentially unchanged since the Great Recession. Even though markets focus heavily on central bank interest rate setting, the mechanism through which monetary policy has its ultimate effect on the price level is through the process of creating the money that people use in transactions for goods and services. Monetary policy’s ability to affect real economic activity -- except for cases of egregious policy errors -- is usually quite limited and is almost always short-lived. Real activity is driven predominantly by factors beyond the control of monetary policy, such as productivity and population growth. Although monetary policy may temporarily affect real economic activity along with the price level, the effectiveness of central bank control of the price level does not depend on the existence of a Phillips curve type correlation between real activity and inflation. Theory and evidence does not suggest that the zero lower bound is impeding the Fed’s capability of attaining its 2 percent inflation objective. Moreover, inflation appears to have some slow-moving components, which allow it to stray sometimes for extended periods from its longer-run trend, so recent experience with inflation does not imply a more permanent departure from the Fed’s target. It seems plausible that there is a broad zone in which the quantity of bank reserves can vary without affecting the price level, which may explain why it has been difficult to find conclusive evidence of economic effects from the Fed’s large-scale asset purchases. The central bank should be cautious about using monetary policy in an attempt to affect real economic activity. It should be even more cautious about using monetary policy to respond to signals of incipient financial instability, an idea that has received considerable attention since the crisis.