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The Fed’s Monetary Policy Tools
Central banks use several different tools to increase or decrease the amount of money in circulation (also known as the money supply).
While the Federal Reserve Board—commonly known as the Fed—could introduce more currency at its discretion to increase the amount of money in the economy, this measure is not used in the United States.
The Federal Reserve Board of Governors is the governing body that manages the Fed and it is required by Congress to achieve the goals of “maximum employment, stable prices, and moderate long-term interest rates.”
Thus, it is responsible for controlling inflation and managing both short-term and long-term interest rates. Using its monetary policy tools, it achieves its goals by controlling how much money circulates throughout the economy.
Key Takeaways
- Central banks have a wide array of tools at their disposal to influence economies. These tools focus on interest rates and the amount of circulating currency.
- The Fed targets a federal funds rate range, which influences the rates that banks charge on loans.
- The Fed can alter the interest rate it pays on the funds that banks hold as reserve balances.
- It can also modify its overnight repo rate and its discount rate to affect financial institution lending and borrowing.
- Altering these rates affects the fed funds rate, which in turn influences broader lending and spending, and ultimately, the money supply.
Federal Funds Target Rate Range
The Fed influences interest rates by monitoring and changing the target range for the federal funds rate (the overnight rate at which banks lend reserves to each other).
It usually sets a 25 basis point range, such as 5.25%-5.50%, which helps maintain a desirable effective federal funds rate (EFFR).
The EFFR is a volume-weighted median of loans between these depository institutions. This rate influences all other rates, including those for bank loans and credit card balances. As a result, it also influences spending and saving, which affects the amount of money circulating throughout the economy.
Interest on Reserve Balances
In the past the Fed influenced the money supply by modifying reserve requirements. This refers to the amount of funds banks are required to hold against deposits in bank accounts.
The Fed no longer requires banks to hold reserves. Its primary tool is now interest on reserve balances (IORB). By paying interest on any reserves that banks keep, it establishes a certain level of support for rates. This keeps the federal funds rate from dropping too far below it.
IORB influences banks to keep money in reserve or deplete their reserves based on demand for loans and the level of rates—adding or subtracting to the supply of circulating money.
The Discount Rate
Banks can borrow money from the Fed using a lending program it calls the discount window. The interest rate set for these loans helps set the top number (the ceiling) for the federal funds rate target range. These loans are short-term, up to 90 days.
By lowering (or raising) the discount rate that banks pay on short-term loans from the Federal Reserve Bank, the Fed effectively increases (or decreases) the liquidity of the banking system.
Overnight Reverse Repurchase Agreements
The Federal Reserve conducts overnight reverse repurchase (ON RRP) agreements, in which it sells a security to an institution, then buys it back the next day for more money. The interest rate used for ON RRPs helps the Fed set the lower rate (the floor) of its fed funds target range.
These reverse repos subtract money from reserves, in essence taking money out of circulation.
Open Market Operations
In open market operations, the Fed purchases and sells securities issued by the U.S. government (such as Treasuries), which can affect the amount of money in circulation.
Open market operations once played a major role in the implementation of the Fed’s monetary policy. Currently, they’re conducted only to help the central bank maintain the “ample level of reserves” it believes is needed to continue to administer the aforementioned rates to influence the effective federal funds rate.
Before 2008, the Fed’s primary tool for affecting the money supply was open market operations. If it wanted to increase the money supply, it bought government securities. This supplied cash to the banks with which it transacted and that increased the money supply. Conversely, if the Fed wanted to decrease the money supply, it sold securities from its account. Doing so removed cash from financial institutions and the funds in circulation.
What Is the Central Bank of the United States?
The Federal Reserve is the central bank of the United States. Broadly, the Fed’s job is to safeguard the effective operation of the U.S. economy and by doing so, the public interest.
Why Would the Fed Increase Interest Rates?
If the economy is overheating and the rate of inflation is rising along with prices consumers pay for all kinds of products, the Fed will step in to cool things down by raising interest rates. When rates are raised, borrowing becomes more expensive so fewer people and businesses engage in it. That process tends to slow spending and other economic activity, which in turn reduces the inflation rate.
What Is U.S. Monetary Policy?
It is the mandate provided to the Fed by the U.S. Congress to support maximum employment, stable prices, and moderate long-term interest rates. The Fed uses its monetary policy tools to implement that policy.
The Bottom Line
The U.S. central bank has a variety of monetary policy tools at its disposal to implement monetary policy, affect the fed funds rate, and alter our nation’s money supply. Currently, the three ways it does this are:
- Modifying the interest rate that it pays on banks’ reserve balances
- Altering the discount rate it charges banks that wish to borrow from it
- Adjusting the overnight reverse repo rate it pays to financial institutions for temporary overnight deposits
By increasing or decreasing the money supply, the Fed aims to maintain stable prices and moderate interest rates, as well as to promote maximum employment.