The term monetary policy refers to the actions that the Federal Reserve undertakes to influence the amount of liquidity (money and credit) in the US economy. Net changes to the overall amount of money and credit affect interest rates and the performance of the US economy.
Macroeconomic policy is usually implemented through two sets of tools: fiscal and monetary policy. Both forms of policy are used to stabilize the economy, which can mean boosting the economy to the level of GDP consistent with full employment. Macroeconomic policy focuses on limiting the effects of the business cycle to achieve the objectives of full employment, price stability and economic growth.
Central banks implement monetary policy by controlling the money supply through several mechanisms. Usually, central banks take action by issuing money to buy bonds, which boosts the supply of money and lowers interest rates or in the case of contractionary monetary policy, banks sell bonds and take money out of circulation.
As of December 3, the U.S. Money Supply (M1) is ( 8.0% YTD) with all equity markets benefiting from the increase in liquidity.
Central banks continuously shift the money supply to maintain a targeted fixed interest rate. Others allow the interest rate to fluctuate and focus instead on targeting inflation rates. Central banks generally try to achieve high output without affording the economy to suffer through large amounts of inflation.
Conventional monetary policy can be ineffective in situations such as a liquidity trap. When interest rates and inflation are near zero, the central bank cannot loosen monetary policy through conventional means.
NASDAQ ( 3.9% YTD), S&P 500 ( 6.2% YTD) and the Russell 2000 ( 12.2% YTD) as of December 31.
Central banks can use unconventional monetary policy such as quantitative easing to help increase output. Instead of buying governement bonds, central banks can implement quantitative easing by purchasing not only government bonds, but other assets as well, such as corporate bonds, stocks and other securities. This allows lower interest rates for a broader class of assets beyond government bonds.
In another example of unconventional monetary policy, the U.S. Federal Reserve made an attempt at such a policy with Operation Twist. Unable to lower interest rates, the Federal Reserve lowered long-term interest rates by purchasing long-term bonds and selling short-term bonds to create a flat yield curve.
The yield of the 10 year note stands at 2.69% ( 12.1% YTD) as of December 31.