What Is a Tight Monetary Policy?

Tight, or contractionary monetary policy is a course of action undertaken by a central bank such as the Federal Reserve to slow down overheated economic growth, to constrict spending in an economy that is seen to be accelerating too quickly, or to curb inflation when it is rising too fast.

The central bank tightens policy or makes money tight by raising short-term interest rates through policy changes to the discount rate, also known as the federal funds rate. Boosting interest rates increases the cost of borrowing and effectively reduces its attractiveness. Tight monetary policy can also be implemented via selling assets on the central bank's balance sheet to the market through open market operations (OMO).

Key Takeaways

  • Tight monetary policy is an action undertaken by a central bank such as the Federal Reserve to slow down overheated economic growth.
  • Central banks engage in tight monetary policy when an economy is accelerating too quickly or inflation—overall prices—is rising too fast.
  • Hiking the federal funds rate–the rate at which banks lend to each other–increases borrowing rates and slows lending.

Tight Monetary Policy

Understanding Tight Monetary Policy

Central banks around the world use monetary policy to regulate specific factors within the economy. Central banks most often use the federal funds rate as a leading tool for regulating market factors.

The federal funds rate is used as a base rate throughout global economies. It refers to the rate at which banks lend to each other and is also known as the discount rate. An increase in the federal funds rate is followed by increases to the borrowing rates throughout the economy.

Rate increases make borrowing less attractive as interest payments increase. It affects all types of borrowing including personal loans, mortgages, and interest rates on credit cards. An increase in rates also makes saving more attractive, as savings rates also increase in an environment with a tightening policy. The Fed may also raise reserve requirements for member banks, in a bid to shrink the money supply or perform open-market operations, by selling assets like U.S. Treasuries, to large investors. This large number of sales lowers the market price of such assets and increases their yields, making it more economical for savers and bondholders.

On August 27, 2020 the Federal Reserve announced that it will no longer raise interest rates due to unemployment falling below a certain level if inflation remains low. It also changed its inflation target to an average, meaning that it will allow inflation to rise somewhat above its 2% target to make up for periods when it was below 2%.

Tight monetary policy is different from—but can be coordinated with—a tight fiscal policy, which is enacted by legislative bodies and includes raising taxes or decreasing government spending. When the Fed lowers rates and makes the environment easier to borrow, it is called monetary easing.

A Benefit of Tight Monetary Policy: Open Market Treasury Sales

In a tightening policy environment, the Fed can also sell Treasuries on the open market in order to absorb some extra capital during a tightened monetary policy environment. This effectively takes capital out of the open markets as the Fed takes in funds from the sale with the promise of paying the amount back with interest.

Tightening policy occurs when central banks raise the federal funds rate, and easing occurs when central banks lower the federal funds rate.

In a tightening monetary policy environment, a reduction in the money supply is a factor that can significantly help to slow or keep the domestic currency from inflation. The Fed often looks at tightening monetary policy during times of strong economic growth.

An easing monetary policy environment serves the opposite purpose. In an easing policy environment, the central bank lowers rates to stimulate growth in the economy. Lower rates lead consumers to borrow more, also effectively increasing the money supply.

Many global economies have lowered their federal funds rates to zero, and some global economies are in negative rate environments. Both zero and negative rate environments benefit the economy through easier borrowing. In an extreme negative rate environment, borrowers even receive interest payments, which can create a significant demand for credit.