How Does the Fed Use Its Monetary Policy Tools to Influence the Economy? (they don't use open market operations to control the federal funds rate)
"The Federal Reserve sets two overnight interest rates: the
interest rate paid on banks' reserve balances and the rate on our
reverse repurchase agreements. We use these two administered rates to
keep a market-
determined rate, the federal funds rate, within a target range set by
the FOMC."
"The Federal Reserve (the Fed)
is the central bank of the United States. As the central bank, it serves
several key functions within the economy. One of the most important
functions of the Fed is to promote economic stability using monetary
policy. The Fed's goals for monetary policy, as defined by Congress, are
to promote maximum employment and price stability.
The Federal Open Market Committee (FOMC) is the monetary
policymaking arm of the Federal Reserve. The FOMC usually meets eight
times per year in Washington, D.C. These two-day meetings include a
review of economic data and financial conditions, briefings by
economists, policy discussions, and a vote on the setting of monetary
policy—including a decision about whether the FOMC will adjust its
target range for the federal funds rate. The federal funds rate is the
interest rate banks charge each other for overnight loans. The Fed sets a
target range for where it wants the interest rates charged to fall
within, and it is the setting of this range that the Fed uses to
communicate its monetary policy position.
Figure 1 The Federal Funds Rate Target Range
SOURCE: Board of Governors of the Federal Reserve System via FRED®, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/graph/?g=COX8, accessed April 4, 2022.
The FOMC conducts monetary policy by
setting the target range for the federal funds rate. This graph shows
the target range, determined by the upper and lower limits, and the
effective federal funds rate within the range.
Over time, as shown in Figure 1,2 the FOMC has moved the
target range up and down as it steers the economy toward maximum
employment and price stability. For example, once the economy recovered
from the global financial crisis, the FOMC moved the target range from
near zero at the end of 2015 up to 2¼ -2½ percent by early 2019. Then
when the COVID-19 pandemic hit, the FOMC quickly moved the target range
back to near zero.
What Is the Federal Funds Rate and Why Is It So Important?
The federal funds rate is a very specific short-term interest rate.
It involves the transfer of funds between banks that maintain accounts
(deposits) with their Federal Reserve Bank; the accounts are called reserve balance
accounts. The federal funds market is where banks that may need money
in their reserve accounts for cashflow reasons go to borrow from banks
that have excess funds in their reserve accounts. Banks who lend funds
act as suppliers of reserves in the federal funds market; banks who
borrow funds act as demanders of reserves in the federal funds market.
The federal funds rate is not "set" by the Fed, but rather determined by
the borrowers and lenders in the federal funds market.
Monetary policy is transmitted through market
interest rates to affect consumers' and producers' spending decisions,
which ultimately moves the economy toward the Fed's objectives—maximum
employment and stable prices. This monetary policy implementation
framework ensures that when the FOMC changes its policy stance (raises
or lowers the target range for the federal funds rate), market interest
rates and financial conditions move in the desired direction.
The FOMC conducts monetary policy by setting the target range for the
federal funds rate (Figure 2, Box 1). Then the Fed implements policy by
using its monetary policy tools to ensure the federal funds rate stays
within the target range (red arrow).
The federal funds rate is important because when the FOMC sets its
target range, it influences many other interest rates in the economy
(Figure 2, Box 2). In fact, by adjusting the target for this rate, the
Fed can influence the spending choices of consumers and producers
(Figure 2, Box 3) and ultimately move the economy toward maximum
employment and price stability (Figure 2, Box 4).
The Fed's Monetary Policy Implementation Toolbox
The Fed uses its monetary policy tools in the implementation phase.
In all, the Fed uses four key tools to help ensure the federal funds
rate stays within the target range set by the FOMC.3 We'll
use a simple supply and demand model (Figure 3) to describe how the
tools work together. Overall, these are the critical tools the Fed uses
because reserves in the banking system are ample. That is, the supply of
reserves, set by the Fed, is large enough that it intersects the demand
curve where it is nearly flat (see Figure 3).
In the ample-reserves framework, the Federal Reserve raises (lowers) its administered rates to move the federal funds rate higher (lower). Small shifts of the supply curve have little or no effect on the federal funds rate.
The Fed's Primary Tool: Interest on Reserve Balances
Today, the Fed's primary tool for adjusting the federal funds rate is
interest on reserve balances. The interest on reserve balances rate
(labeled "IORB rate" in Figure 3) is the interest rate paid on funds
that banks hold in their reserve balance account at a Federal Reserve
Bank. For banks, this interest rate represents a risk-free investment
option. Importantly, the interest on reserve balances rate is an
"administered rate," which means it is set by the Fed and not determined
in a market (like the federal funds rate is). In fact, there are two
key concepts that ensure interest on reserves is an effective tool.
The first concept is the reservation rate, which is the lowest
rate that banks are willing to accept for lending out their funds.
Banks can deposit their funds at the Federal Reserve and earn the
interest on reserve balances rate. Because depositing funds at the Fed
is a risk-free option, banks will likely not be willing to lend their
funds in the federal funds market for a lower interest rate than they
can earn from depositing their funds at the Fed. So, the interest on
reserve balances rate serves as a reservation rate for banks.
The second concept is arbitrage, which is the simultaneous
purchase and sale of funds (or goods) in order to profit from a
difference in price. For example, let's assume reserves are trading in
the federal funds market at 2 percent (i.e., the federal funds rate is 2
percent) and that reserves (deposits) at the Fed earn 2.5 percent
(i.e., the interest on reserve balances rate is 2.5 percent). Banks will
quickly see that they can borrow funds in the federal funds market at 2
percent and deposit those funds at the Fed and earn the interest on
reserve balances rate of 2.5 percent, which means that they can earn a
profit of 0.5 percent (the difference between the rates).The increase in
demand for funds in the federal funds market will put upward pressure
on the federal funds rate, and the federal funds rate will rise toward
the interest on reserve balances rate. This upward pressure on the
federal funds rate will continue until the federal funds rate has risen
to the level that banks no longer see the opportunity to profit.
So, arbitrage ensures that the federal funds rate does not fall far below the interest on reserve balances rate.
Arbitrage is the reason why these short-term rates remain closely
linked. In fact, arbitrage is what makes interest on reserve balances an
effective tool for guiding the federal funds rate. Because the Fed sets
the interest on reserve balances rate directly, the Fed can steer the
federal funds rate down or up by lowering or raising the level of the
interest on reserve balances rate. As a result, interest on reserve
balances is the Fed's primary tool for adjusting the federal funds rate,
but the Fed has other tools that play supporting roles.
Setting a Floor for the Federal Funds Rate: The Overnight Reverse Repurchase Agreement Facility
Interest on reserve balances is available only to banks and a few
other institutions. The Fed has an overnight reverse repurchase facility
that is open to a broader set of financial institutions. This facility
allows these financial institutions to deposit their funds at a Federal
Reserve Bank and earn the overnight reverse repurchase agreement rate
offered by the Fed. The overnight reverse repurchase agreement rate
(labeled "ON RRP rate" on Figure 3) works for these institutions similar
to the way the interest on reserve balances rate works for banks. So,
this rate acts like a reservation rate for these financial institutions,
and the overnight reverse repurchase agreement rate interacts with
other short-term market rates through arbitrage. The overnight reverse
repurchase agreement facility is a supplementary tool because the rate
the Fed sets for it helps set a floor for the federal funds rate (Figure
4).
Figure 4 Steering the Federal Funds Rate
SOURCE: Federal Reserve Bank of New York and Board of
Governors of the Federal Reserve System via FRED®, Federal Reserve Bank
of St. Louis;
https://fred.stlouisfed.org/graph/?g=LP47, accessed April 4, 2022.
The Fed implements monetary policy by using
its monetary policy tools, such as the interest of reserve balances
rate (red) and overnight reverse repurchase agreement rate (blue), to
ensure interest rates are consistent with the federal funds rate
target.
Setting a Ceiling for the Federal Funds Rate: The Discount Window
The discount rate is the rate charged by the Fed for loans obtained through the Fed's discount window.
Because banks will not likely borrow at a higher rate than they can
borrow from the Fed, the discount rate acts as a ceiling for the federal
funds rate: It is set higher than the interest on reserve balances rate
and the overnight reverse repurchase agreement rate (Figure 5).
When the Federal Reserve lowers its administered
rates, the end points of the demand curve shift down. The vertical
supply curve is unchanged. The demand curve intersects the supply curve
at a lower federal funds rate. In general, the Fed tends to lower all
the administered rates by the same amount, keeping the spread between
the rates constant.
The Final Tool: Open Market Operations
As noted above, the Fed's current method for implementing monetary
policy relies on banks' reserves remaining "ample." So, if the Fed needs
to add reserves to ensure they remain ample, it does so by buying U.S.
government securities in the open market. This action is known as open market operations.
When the Fed buys securities, it pays for them by depositing funds into
the appropriate banks' reserve balance accounts, adding to the overall
level of reserves in the banking system. As Figure 3 shows, open market
operations can be used to shift the supply curve left or right. Prior to
2008, open market operations were the Fed's primary monetary policy
tool, which it used daily to make sure the federal funds rate hit the
FOMC's target. Today this tool is mainly used to ensure that reserves
remain ample.
Now that you understand the Fed's implementation tools, let's see how
the Fed uses them to achieve its two goals: maximum employment and
price stability.
Expansionary Monetary Policy Using the Fed's Tools
Suppose the following: The economy weakens, with employment falling
short of maximum employment, and the inflation rate has been steady at
around 2 percent but is showing signs of decreasing. The FOMC might
decide to conduct monetary policy by lowering its target range for the federal funds rate. To implement
that monetary policy, it would decrease its administered rates—the
interest on reserve balances rate, overnight reverse repurchase
agreement rate, and discount rate—to ensure the market-determined
federal funds rate stays within the target range (see Figure 5). These
actions would transmit to other interest rates and broader financial
conditions:
Lower interest rates decrease the cost of borrowing money, which
encourages consumers to increase spending on goods and services and
businesses to invest in new equipment.
The increase in
consumption spending increases the overall demand for goods and services
in the economy, which creates an incentive for businesses to increase
production, hire more workers, and spend more on other resources.
As
these increases in spending ripple through the economy, likely moving
the unemployment rate down toward its full employment level, inflation
could possibly move up.
So, the Fed's monetary policy implementation tools can be effective
for moving the economy back toward maximum employment and price
stability when the economy is stalling.
Contractionary Monetary Policy Using the Fed's Tools
Suppose the following: The economy is showing signs of overheating,
with the unemployment rate very low and businesses finding it hard to
fill jobs, and the inflation rate has been above the Fed's 2 percent
target for quite some time and is rising. In this case, the FOMC might
decide to conduct monetary policy by raising its target range for the federal funds rate. To implement
that monetary policy, it would increase its administered rates—the
interest on reserve balances rate, overnight reverse repurchase
agreement rate, and discount rate—to ensure the federal funds rate stays
within the target range. These actions would transmit to other interest
rates and broader financial conditions:
Higher interest rates increase the cost of borrowing money and
raise the incentive to save, which dampens consumer spending on some
goods and services and slows businesses' investment in new equipment.
The
decrease in consumption spending decreases the overall demand for goods
and services in the economy, which will likely lead to a decrease in
production levels, fewer employees hired, and less spending on other
resources.
As these decreases in spending ripple through the
economy, demand for workers could lessen, inflationary pressures would
diminish, and the inflation rate would fall back toward 2 percent.
So, higher interest rates can be used to move the economy back to
maximum employment and price stability when the economy is overheating.
Conclusion
The Fed has a congressional mandate of maximum employment and price
stability. The FOMC conducts monetary policy by setting the target range
for the federal funds rate. Then the Fed uses its monetary policy tools
to implement the policy, which guides market interest rates toward the
Fed's desired setting of policy. The Fed ensures there are ample
reserves in the banking system and uses its administered rates to steer
the federal funds rate into the FOMC's target range: Interest on reserve
balances is the Fed's primary tool for adjusting the federal funds
rate; the overnight reverse repurchase agreement facility is a
supplementary tool that sets a floor for the federal funds rate; and the
discount rate serves as a ceiling for the federal funds rate. Changes
in the federal funds rate are transmitted to other interest rates
through arbitrage and affect the decisions of consumers and businesses.
Their decisions ultimately move the economy toward maximum employment
and price stability.
2 The effective federal funds rate is the
rate used in the figures in this article. On any given day, there are
many transactions that settle at slightly different federal funds rates.
The effective federal funds rate is the volume-weighted median rate of
these transactions.
3 The Fed recently introduced two
repurchase agreement (repo) backstop tools, the standing overnight repo
facility and the foreign and international monetary authorities repo
facility. These are used by specific counterparties to help set a
ceiling on repo rates. We do not discuss them here because this article
is targeted toward a principles of economics audience.
Arbitrage: The simultaneous purchase and sale of funds (or goods) in order to profit from a difference in price.
Discount rate: The interest rate charged by the Federal Reserve to banks for loans obtained through the Fed's discount window.
Facility: A standing program targeted at a set of
counterparties for depositing or lending. The Fed has permanent
facilities (like the discount window and the overnight reverse
repurchase agreement facility) as well as temporary facilities (like
those implemented during the Financial Crisis of 2007-09 and the
COVID-19 pandemic).
Federal Open Market Committee (FOMC): A Committee created by
law that consists of the seven members of the Board of Governors; the
president of the Federal Reserve Bank of New York; and, on a rotating
basis, the presidents of four other Reserve Banks. Nonvoting Reserve
Bank presidents also participate in Committee deliberations and
discussion.
Maximum employment: The highest level of employment that an economy can sustain while maintaining a stable inflation rate.
Open market operations: The buying and selling of government
securities through primary dealers by the Federal Reserve. When the
securities are bought or sold, reserves in the banking system are
increased or decreased, respectively.
Price stability: A low and stable rate of inflation maintained over an extended period of time.
Reservation rate: The lowest rate of return that banks are willing to accept for lending out funds.
Reserve balances (reserves): The deposits a bank maintains in its account with a Federal Reserve Bank."
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