For the past several months, it has been hard to avoid debate over the debt ceiling and concerns over inflation. For the average retail shareholder, the debt ceiling is a nebulous term. It is important, but probably does not affect how the individual investor trades. Inflation squeezes the pocketbook of individual shareholders. Both are part of the country’s overall monetary policy, which definitely has an impact on the markets.

So what does it mean when government officials talk about monetary policy and how does it affect the markets? Simply put, Monetary policy is a broad term that includes the financial tools used by the central bank to control money supply and economic growth. In the United States, the Federal Reserve Bank controls the country’s monetary policy, always with an eye on two overriding goals as mandated by Congress: keeping employment high and inflation under control.

“The Fed” is the nation’s monetary policy authority, influences the availability and cost of money and credit to promote a healthy economy. The dual mandate of keeping employment and inflation stable implies a third, lesser-known goal of moderating long-term interest rates.

Achieving maximum employment is difficult to measure and the meaning of maximum employment can change with the structure and dynamics of the labor market. That’s why the Fed doesn’t specify a fixed goal for employment. Instead, it assesses employment and adjust the economy to address employment shortfalls. In general, maximum unemployment – a state that when anyone who wants a job can get one – is generally around 4%.

As for inflation, Fed policymakers believe that a 2% inflation rate, as measured by the annual change in the price index for personal consumption expenditures, is most consistent over the longer run with its mandate for stable prices. The Fed began explicitly stating the 2 percent goal in 2012.

The Fed implements monetary policy primarily by influencing the federal funds rate, the interest rate that financial institutions charge each other for loans in the overnight market for reserves. Changes in the federal funds rate tend to cause changes in other short-term interest rates, which ultimately affect the cost of borrowing for businesses and consumers, the total amount of money and credit in the economy, and employment and inflation.

To keep price inflation in check, the Fed can use its monetary policy tools to raise the federal funds rate. Monetary policy in this case is said to “tighten” or become more “contractionary” or “restrictive.” To offset or reverse economic downturns and bolster inflation, the Fed can use its monetary policy tools to lower the federal funds rate. Monetary policy is then said to “ease” or become more “expansionary” or “accommodative.”

The Fed has raised borrowing costs at 10 consecutive meetings (the most recent earlier in May), pushing its benchmark rate to between 5 and 5.25%. While inflation has cooled since last summer, it's still more than twice as high as the central bank's target of 2%.

The Fed has traditionally used three tools to conduct monetary policy: reserve requirements, the discount rate, and open market operations. In 2008, the Fed added paying interest on reserve balances held at Reserve Banks to its monetary policy toolkit. More recently the Fed also added overnight reverse repurchase agreements to support the level of the federal funds rate.

When faced with severe disruptions, the Fed can turn to additional tools to support financial markets and the economy. The recession that followed the 2007–2008 financial crisis was so severe that the Fed used open market operations to lower the federal funds rate to near zero. To provide additional support, the Fed also used tools that were not part of the traditional toolkit to lower borrowing costs for consumers and businesses. One of these tools was purchasing a very large amount of assets such as Treasury securities, federal agency debt, and federal agency mortgage-backed securities. These asset purchases put additional downward pressure on longer-term interest rates, including mortgage rates, and helped the economy recover from the deep recession. In addition, the Fed opened a series of special lending facilities to provide much-needed liquidity to the financial system. The Fed also announced policy plans and strategies to the public, in the form of “forward guidance.” All of these efforts were designed to help the economy through the recession.

The Fed used similar tools during the pandemic to help stabilize the economy.

So even though monetary policy might not directly affect you as a retail shareholder, the levers the Fed pulls to stabilize the economy can move markets. Its actions are worth watching.