Flexible dual mandate and market focus
Unlike most central banks the Federal Reserve operates under an explicit dual mandate and pursues a monetary policy of “flexible inflation targeting“. This means it seeks to promote financial conditions that would bring both inflation and economic operating rates, particularly the unemployment rate, towards mandated levels over the medium term. Moreover, the Fed has considerable flexibility regarding the time horizon for meeting its economic objectives.
For the transmission of monetary policy to the boarder economy the Federal Reserve must pay particularly close attention to financial market conditions. As William Dudley of the New York Federal Reserve put it: “Divergences between short-term interest rates and financial conditions often appear to be larger and more persistent in the United States than in most other advanced economies. There are several reasons for this. First, the U.S. financial system depends less on its banking system to intermediate financial flows…Second,…U.S. residential housing is financed mainly by 30-year fixed-rate mortgages, rather than—as is the case in most other countries—adjustable-rate mortgages with rates that much more closely track their central banks’ short-term interest rate targets. Third, the equity market plays a much more important role in the United States than elsewhere.”
Federal Reserve policy must consider the influence of financial markets on several levels. According to the New York Fed’s head of markets group Simon Potter, “for monetary policy to achieve its objectives, markets must function well enough to transmit the stance of policy, both from the markets in which the Federal Reserve directly transacts to its policy target [the fed funds rate], and then onward from that target to other money markets, and eventually to those asset prices which directly affect real activity.”