BETSEY STEVENSON: At a press conference following the one year anniversary of the COVID-19 pandemic, Federal Reserve Chairman Jerome Powell explained that the Fed would be keeping interest rates at close to zero for quite some time in order to help the economy recover.

JUSTIN WOLFERS: Even though unemployment had fallen a bit, it was still high compared to pre-pandemic levels. Powell also explained that inflation was below the Fed's target of 2% per year.

BETSEY STEVENSON: The Fed sets monetary policy, which is all about how central bankers help keep the macro economy working smoothly. Monetary policy is our subject on this week's Think Like an Economist with me, Betsey Stevenson.

JUSTIN WOLFERS: And I'm <PRESIDIO_ANONYMIZED_PERSON>. We're teaching you the tools from economics to help transform your life and the world around you, whether interest rates are high or low. Nestaran Tavakoli-Far is with us.

NESTARAN TEVAKOLI-FAR: In recent episodes, we've been talking about the impact of interest rates on the macro economy. And in this episode, we're going to dive into the role central banks play in setting interest rates and helping to keep the economy operating at potential.

BETSEY STEVENSON: We're going to take a look at what goes on in the World Central Banks, like the Federal Reserve in the United States, the European Central Bank, or ECB, in Europe, the Bank of England or Bank of Japan, or in countries like Australia or Canada or India, the central bank is called the Reserve Bank. And in China, it's called the People's Bank of China.

JUSTIN WOLFERS: Every country has a central bank, and in most cases, they adjust the interest rate to try to tame the ups and downs of the business cycle. Most central banks focus on trying to achieve low and stable inflation, as well as low and stable unemployment. But they affect those outcomes indirectly, primarily by adjusting the interest rate.

NESTARAN TEVAKOLI-FAR: We're going to focus on the Fed, which is the US Federal Reserve, the central bank in the US. But the mechanics are pretty similar in most of the world's leading economies.

JUSTIN WOLFERS: Eight times a year, the Fed holds a meeting called the Federal Open Market Committee to set interest rates. And it's attended by the Fed's governors, as well as the presidents of the regional Federal Reserve banks.

BETSEY STEVENSON: The center of the US system is the Federal Reserve Board of Governors, and the chairman of the Federal Reserve Board runs the Federal Open Market Committee, which has to reach a decision across the 12 voting members of what to do about interest rates and monetary policy.

Well this is a meeting, perhaps like a meeting you've been to, where you have to make a decision. The decisions here are pretty high stakes.

JUSTIN WOLFERS: Picture a room, and [INAUDIBLE] in the room, which has a big table. And the chair of the Federal Reserve sitting right in the middle. So right now, that's Jay Powell. He'll start by deciding who's going to speak, and in what order.

NESTARAN TEVAKOLI-FAR: And exactly what are these experts all discussing at the Federal Open Market Committee?

JUSTIN WOLFERS: There are three main questions they're trying to answer. First, what are your forecasts for the US economy? Second, what are the right policy choices given those forecasts? And third, how should the Fed communicate its plans to the public?

NESTARAN TEVAKOLI-FAR: So first, it's about forecasts?

JUSTIN WOLFERS: Yeah. So the chair starts by asking everyone to share their views about the current state of the economy, and their projections for where things are going to go. This is where we can really hear about regional differences from the Fed bank presidents from around the country who shared their findings and analysis from crunching the numbers and also from having spoken to local businesses as well.

NESTARAN TEVAKOLI-FAR: To clarify, in the US, there are regional Federal Reserve banks, and those presidents all come to the meeting to share their views and take turns as voting members.

BETSEY STEVENSON: Right. And that helps paint a full picture where different experts think the economy might be headed. Because behind the people attending the FOMC meeting are hundreds of people studying the US economy and trying to forecast where it's headed.

JUSTIN WOLFERS: Because the big decision, which is what's the right policy choice, depends on understanding exactly what's going on with the economic outlook.

NESTARAN TEVAKOLI-FAR: So they're discussing what should happen to the interest rate.

BETSEY STEVENSON: Remember the real interest rate is the opportunity cost of spending for consumers who might decide it isn't worth saving as much if interest rates go down, or who might decide to borrow to buy a car or a house because the interest rates have gone down.

Similarly, businesses might decide to borrow more or make greater investments if interest rates go down. Of course, the opposite is also true. They raise rates, both consumers and businesses might decide to spend less today, save more for tomorrow.

NESTARAN TEVAKOLI-FAR: The Fed will raise the real interest rate when the economy is overheating and inflation is high so that people will spend less, and it will lower the interest rate when the economy may be underperforming and inflation's low, so that people spend more today.

BETSEY STEVENSON: Yes. Remember, the Fed is aiming for stable inflation and a sustainable employment rate, which they influence through interest rates.

JUSTIN WOLFERS: Once they've debated all the options about how these are going to affect the economy, the Fed chair tends to recommend a course of action, and the rest of the committee votes on it.

NESTARAN TEVAKOLI-FAR: And the final question at the meeting is about how the Fed should communicate its plans to the public.

JUSTIN WOLFERS: Yeah. Fed chairs need to be really careful about what they say, and to whom. Even a small offhand comment at a party has been known to leak out, get spread by the press, and make big waves in financial markets.

BETSEY STEVENSON: The Fed chair issues a statement and holds a press conference after every meeting, explaining their decisions. And they also publish their forecasts. This is relatively new that the Fed aims for this greater transparency. It's all about trying to help people set clear expectations.

NESTARAN TEVAKOLI-FAR: And we talk about expectations a lot when we talk about the macro economy.

JUSTIN WOLFERS: That's right. Expectations are absolutely critical to macroeconomics. It's because when people are trying to decide what to do, they're not just thinking about the state of things today. They're also thinking about the future. So if people think the Fed is going to raise rates in the near term, well they may make different decisions than if they thought that the interest rates would continue to be low for a while.

BETSEY STEVENSON: The Fed tries to shape expectations through these statements and press conferences and releasing their forecasts. And they try to give some guidance on what they may do in the future. This is known as forward guidance, and it's all about trying to shape expectations.

JUSTIN WOLFERS: Language really matters here. Recently, the Fed said it wasn't going to raise rates based on simple forecasts of an economic recovery. They said they were going to wait for evidence of a recovery.

BETSEY STEVENSON: This led them to say that they didn't expect to raise interest rates for a period of three years. The idea is to convince people they can rely on the Fed to keep interest rates low, therefore spending in the economy high for the next three years. The hope is that this spurs more business investment.

NESTARAN TEVAKOLI-FAR: The Fed's two goals are stable prices, or stable inflation, and a maximum sustainable employment rate. These are known as the Fed's dual mandate. Now let's dig into these a little more. First, stable prices. What do we mean by this?

JUSTIN WOLFERS: When inflation is sufficiently low and stable, most people can make plans and basically ignore inflation. They can focus on doing business.

BETSEY STEVENSON: Over the past few decades, most central banks have turned to targeting a very specific low inflation rate and trying to keep inflation there. Most developed countries aim to keep inflation around 2% a year.

JUSTIN WOLFERS: The Fed started announcing its target to the public in 2012 with the hopes that this would convince people all across the economy that inflation would in fact be low and stable.

BETSEY STEVENSON: By being really transparent about the inflation rate they're targeting, the hope is that the expectation will trickle through the economy as price setters raise their prices in line with that low and stable expected inflation rate of 2%.

JUSTIN WOLFERS: So the goal was if we convince people there'll be low inflation, that'll create the reality of low inflation.

NESTARAN TEVAKOLI-FAR: We always hear about the dangers of inflation, though. So why do we have 2% inflation? Why do we want any inflation at all?

JUSTIN WOLFERS: There's a few reasons for this. One is that if we had no inflation at all, it's going to be really hard for employers to cut wages if the economy were to turn down. If there's inflation, you can cut people's real wages just by not adjusting their money wages. And that can help buffer some economic shocks.

BETSEY STEVENSON: OK, but people really don't want to hear about, whoa, isn't this great? It lets us cut people's wages in a secret way. But in a recession or a downturn, if employers can't cut the real wage, they may have to lay people off instead. So 0% inflation might lead to higher unemployment during recessions.

JUSTIN WOLFERS: Another reason is that by keeping inflation above zero, the Fed has more room to cut the real interest rate.

BETSEY STEVENSON: This is a really important concept called the zero lower bound. So the Fed wants to try to lower interest rates if we're in a recession. But it can't really lower rates below 0%, because the real interest rate is the nominal interest rate minus inflation. So if there's no inflation, then the Fed has less room to maneuver to cut the real interest rate.

This has been one of the things that's been challenging central banks across the globe over the last few decades.

JUSTIN WOLFERS: There's something else. If we were to target a 0% rate of inflation, well there's the risk that instead of inflation, we'll end up with deflation.

NESTARAN TEVAKOLI-FAR: Deflation is when overall price levels are falling, which is the same as a negative inflation rate.

BETSEY STEVENSON: Yeah, so it sounds great, right? Now we all want things to be on sale. So if I told you that you're thinking about, I don't know, going out and buying a new car, but it might be 5% cheaper if you wait, what are you likely to do?

NESTARAN TEVAKOLI-FAR: I will probably wait.

BETSEY STEVENSON: Right. That is the problem of deflation.

JUSTIN WOLFERS: If everyone does that, no one's buying cars. The economy enters a recession. It's worse than that. You've got deflation, the economy enters a recession, that's going to cause more

NESTARAN TEVAKOLI-FAR: Deflation.

JUSTIN WOLFERS: Exactly. And so it can create a spiral of more deflation, more recession, more deflation.

BETSEY STEVENSON: The last reason that central banks tend to not aim for 0% inflation is that many economists believe that the measured inflation rate overstates the actual inflation rate. Remember in our earlier episode about inflation, we looked at how inflation rate calculations often don't take into account things such as quality improvement in many products, which might effectively reduce the cost of living.

So if we aimed for 0% measured inflation, we could actually end up with deflation.

NESTARAN TEVAKOLI-FAR: So they aim for 2% inflation and interest rates to try to keep inflation stable at 2%. But employment is also important to the Fed too, right?

BETSEY STEVENSON: Yes, the Fed's dual mandate is also about maximum sustainable employment. This is what happens when the economy is operating at its potential. It doesn't get rid of unemployment, because some unemployment is caused by other factors like the time it takes you to look for a job, or if you need to retrain to keep up with changes in the economy.

JUSTIN WOLFERS: So what it's trying to do is target the lowest sustainable rate of unemployment, or the highest sustainable level of employment.

NESTARAN TEVAKOLI-FAR: We've gone through what happens at the Federal Open Market Committee. How does the Fed choose the interest rate?

BETSEY STEVENSON: Well policymakers start by thinking about something called the neutral interest rate. This isn't an interest rate that you can look up in the newspaper, because it's really more of an idea than a specific interest rate. Think of it as the Goldilocks interest rate that will cause the economy to be not too hot, nor too cold.

JUSTIN WOLFERS: It's a really important baseline, because the idea is if you set the real interest rate higher than its neutral rate, it'll lead output to grow a bit more slowly than its potential, leading to unused resources and unemployment. Or if you keep the real interest rate lower than the neutral rate, it'll push output to grow faster than potential, potentially sparking inflation.

BETSEY STEVENSON: Economists used to think that the neutral real interest rate was about 2%, but it's been falling as part of a trend called secular stagnation. We'll talk about secular stagnation in a bonus episode with Larry Summers. But the implication is that today the neutral real interest rate is probably less than 1%.

NESTARAN TEVAKOLI-FAR: So we have the neutral real interest rate, which is an important baseline. What else do these central bankers look at when they're setting the interest rate?

JUSTIN WOLFERS: They also compare inflation to their inflation target. If inflation is higher than the Fed's target, this is a signal to the Fed that it should set the interest rate higher than the neutral real rate, so it can encourage people and businesses to spend less and save more.

And that spending less will reduce demand, which in turn will lead to lower inflation.

BETSEY STEVENSON: It's not just the Fed that targets inflation. So does the European Central Bank, the Reserve Bank of Australia, the Bank of Japan, the Bank of England, and just about every major country. In each case, policymakers look at the gap between inflation and the target level of inflation to guide them on just how much they need to change the real interest rate.

NESTARAN TEVAKOLI-FAR: And just a moment ago, you mentioned the output gap, which is also closely related to the unemployment rate.

JUSTIN WOLFERS: Yeah. When the economy is producing less than its potential, then there are lots of unused resources, including unemployed workers. That's a problem. And so central bankers also think about the output gap and how they can address it when they're setting rates.

BETSEY STEVENSON: Nearly every central bank takes a look at the state of their labor market and the output gap when setting interest rates. But they talk about it differently. In countries like the US or Australia, the central bank is explicitly told by the government that it needs to adjust rates in response to both inflation and employment.

JUSTIN WOLFERS: In other countries, the government tells the central bank to focus only on inflation. For instance, the European Central Bank says that its main aim is to keep inflation low. But if you remember the Phillips curve, you'll know that the output gap and unemployment also affect inflation.

And so the European Central Bank also ends up adjusting interest rates in response to output and the state of the labor market. But it does so because those things affect the future of inflation.

BETSEY STEVENSON: When output exceeds potential, central banks tend to respond by setting real interest rates a bit higher, understanding that this will reduce demand, therefore reduce the output gap and reduce inflation.

JUSTIN WOLFERS: Or if output's below potential and people are unemployed, the central bank will typically try to help people get back to work by setting a real interest rate a bit lower. Their hope is that this will stimulate more spending, leading to more output and more hiring.

NESTARAN TEVAKOLI-FAR: So far you've bee talking about the real interest rate, but the Fed sets the nominal interest rate.

JUSTIN WOLFERS: Yeah. And so this means that once the Fed decides on what the real interest rate should be, it needs to add inflation to it in order to get the nominal interest rate, which is what it'll ultimately announce.

NESTARAN TEVAKOLI-FAR: And we call this the federal funds rate.

JUSTIN WOLFERS: Yeah, the Fed adjusts a very specific interest rate. We call that the federal funds rate. But as we'll talk about in a moment, changes in that rate end up affecting nearly every other interest rate in the economy from car loans to business investment loans.

NESTARAN TEVAKOLI-FAR: So to wrap up, central banks like the Fed start by thinking about a baseline neutral real interest rate, and they'll set that rate a bit higher if inflation is likely to exceed its target. They'll adjust it a bit lower if unemployment is likely to be high because output is too weak.

And of course, they actually set a nominal interest rate, which is equal to their preferred real interest rate plus inflation.

JUSTIN WOLFERS: There's one more important thing. Central bankers don't just look at today's inflation or unemployment numbers. They're also looking at forecasts of the future path of the economy so they can predict and get ahead of any looming problems.

NESTARAN TEVAKOLI-FAR: Now how exactly does the central bank set the interest rate?

BETSEY STEVENSON: As we discussed, the Federal Reserve sets one main interest rate called the federal funds rate. It's a pretty strange interest rate. It's not one you're going to face in your daily life, because it's the rate that banks charge each other for overnight loans.

JUSTIN WOLFERS: But that right really matters because when banks can borrow from each other at low rates, they can lend to you and I and to millions of other people and businesses at low rates, too. So the effects of changing the federal funds rate ripple out and affect the rate on just about everything, from the rate on personal loans to the interest rate on car loans to business loans.

NESTARAN TEVAKOLI-FAR: You're saying that the federal funds rate is an overnight interest rate, or the interest rate on a one day loan. Most loans lasts longer than this, though.

JUSTIN WOLFERS: Yeah. But when you think about a longer loan, let's say a two day loan, we could think about a two day loan as a one day loan from today 'till tomorrow, and then another one day loan from tomorrow 'till the next day. That means the interest rate on a two day loan will be equal to the overnight interest rate today plus whatever we expect the overnight interest rate to be tomorrow.

BETSEY STEVENSON: You can take this logic even further. The interest rate on a 30 day loan is equal to today's overnight interest rate plus the interest rate people expect the Fed to charge for each of the subsequent 29 days. So now you're getting that sense of why expectations really matter.

What interest rate are they going to pay each and every day over, say, the next 30 days, the next 60 days, the next year.

JUSTIN WOLFERS: Follow that logic far enough and you'll see that the changes in the overnight interest rate affect the one year interest rate, the two year interest rate, the 10 year interest rate, and so on.

NESTARAN TEVAKOLI-FAR: So how does the Fed set this overnight interest rate that we call the federal funds rate?

JUSTIN WOLFERS: One answer is that it's complicated. The simpler answer is that the Fed effectively announces that it's willing to borrow or lend any amount of money to banks at a particular rate. So if the Fed wants to set the federal funds rate at 1.5%, it'll say that it's willing to borrow any amount of money at 1.5%.

BETSEY STEVENSON: Overnight from these banks. By being willing to borrow any amount of money at a particular rate, it's effectively setting kind of a floor, meaning that other banks would rather lend money to the Fed at that rate than lend money to anybody else at a lower rate.

So those banks will only lend money out to other banks or to you or to me if the rate is at least as high as that floor.

JUSTIN WOLFERS: The Fed refers to this as the ample reserves framework, or sometimes the floor framework. And this is essentially how the Fed sets a floor, or a lower bound, or a minimum interest rate that one financial institution will be willing to charge to lend to another.

BETSEY STEVENSON: And the Fed also sets a ceiling. Basically it says it will lend to any amount of money at another interest rate that you or I might call the ceiling, but they call the discount rate. If a bank can borrow money from the Fed at, say, 1.75%, it'll never borrow money from others at a higher rate.

JUSTIN WOLFERS: So there's a floor on the federal funds rate of say 1.5% and a ceiling of say 1.75%. What that means is that the federal funds rate will end up somewhere in that very narrow window.

BETSEY STEVENSON: By the way, all of this used to operate very differently. So if you hear an economist talking about open market operations, they're typically talking about how the Fed used to operate.

NESTARAN TEVAKOLI-FAR: What about Quantitative Easing? I keep reading newspaper headlines about this.

JUSTIN WOLFERS: And sometimes they'll just call it QE. Now remember we said that the Fed normally operates by affecting the federal funds rate, which is the interest rate on overnight loans? Well quantitative easing is just a terrible term for when the Fed tries to buy and sell long-term bonds as a way of changing long-term interest rates.

So instead of changing the overnight interest rate, quantitative easing is about lowering long-term interest rates, like the rate on 10 year loans.

BETSEY STEVENSON: You'll often hear people talk about the Fed's balance sheet. That's about the amount of these long term bonds that they're holding on to, and whether they plan to sell them or buy more of them in the future.

JUSTIN WOLFERS: And all of that is about affecting long-term interest rates.

NESTARAN TEVAKOLI-FAR: We've been talking so much about what central banks do and what financial institutions do, and they all sound so abstract and distant from our lives. How do all these adjustments to the federal funds rate impact us as everyday people living and working in the economy?

BETSEY STEVENSON: It does affect us all, because these changes in the market for overnight loans will ripple through the economy and lead banks to change the interest rate they charge consumers for credit cards, loans, mortgages, et cetera. So the federal funds rate will really trickle out through the entire economy.

JUSTIN WOLFERS: And it doesn't just affect the interest rate you're going to pay on your car loan or on your mortgage.

BETSEY STEVENSON: Remember that the interest rate is all about changing the value of consuming today versus consuming tomorrow.

JUSTIN WOLFERS: And so it's going to change the spending plans that make most sense for you. If interest rates are high, you should probably save more because it's really worth saving. And if interest rates are low, maybe there's a stronger case to be made for spending more today.

BETSEY STEVENSON: And more demand today means businesses will hire more people. That also means more output, and there could be supply constraints so we could see prices rising, pushing up inflation. It all really depends on how much excess capacity there is in the economy.

JUSTIN WOLFERS: So all of this is going to shape the opportunities you're offered. Because the state of the labor market is really dependent on what the Fed does. It's also going to affect the prices that you face at the supermarket, because inflation is largely determined by the Fed's actions.

NESTARAN TEVAKOLI-FAR: And what can we be thinking about over the next few days so that we can really get our heads around all this?

JUSTIN WOLFERS: You're going to be making a lot of decisions over the next week. Might be whether to apply for a new job. It might be whether to refinance your mortgage. It might be whether to buy something today before the prices go up or down. As you're making each of those decisions, think about the role that the central bank in your country is playing in shaping your decisions.

BETSEY STEVENSON: Yeah, one way to do that would be to think about, what would you actually do if interest rates were higher? Or what would you do if interest rates were lower? Then start to think about multiplying that by, well, all the people in your country. And that'll give you a sense of how you think the macro economy will move.

NESTARAN TEVAKOLI-FAR: Betsey, Justin, thanks for walking us through monetary policy.

JUSTIN WOLFERS: This one's near and dear to our hearts. And as my first ever job out of college was working for the central bank, hey Betsey, what was yours?

BETSEY STEVENSON: It was working for the central bank at the Federal Reserve Board in Washington, DC.