What are the tools of U.S. monetary policy?
The Fed can't control inflation or influence output and employment directly;
instead, it affects them indirectly, mainly by raising or lowering a
short-term interest rate called the "federal funds" rate. Most
often, it does this through open market operations in the market for
bank reserves, known as the federal funds market.
What are bank reserves?
Banks and other depository institutions (for convenience, we'll
refer to all of these as "banks") keep a certain amount of
funds in reserve to meet unexpected outflows. Banks can keep these reserves
as cash in their vaults or as deposits with the Fed. In fact, banks are
required to hold a certain amount in reserves. But, typically, they hold
even more than they're required to in order to clear overnight checks,
restock ATMs, and make other payments.
What is the federal funds market?
From day to day, the amount of reserves a bank wants to hold
may change as its deposits and transactions change. When a bank needs
reserves on a short-term basis, it can borrow them from other banks that
happen to have more reserves than they need. These loans take place in
a private financial market called the federal funds market.
rate on the overnight borrowing of reserves is called the federal funds
rate or simply the "funds rate." It adjusts to
balance the supply of and demand for reserves. For example, if the supply
of reserves in the fed funds market is greater than the demand, then
the funds rate falls, and if the supply of reserves is less than the
demand, the funds rate rises.
What are open market operations?
The major tool the
Fed uses to affect the supply of reserves in the banking system is open
is, the Fed buys and sells government
securities on the open market. These operations are conducted by the
Federal Reserve Bank of New York.
Suppose the Fed wants the funds rate
to fall. To do this, it buys government securities from a bank. The Fed
then pays for the securities by increasing
that bank's reserves. As a result, the bank now has more reserves than
it wants. So the bank can lend these unwanted reserves to another bank
in the federal funds market. Thus, the Fed's open market purchase increases
the supply of reserves to the banking system, and the federal funds rate
When the Fed wants the funds rate to rise, it does the reverse,
that is, it sells government securities. The Fed receives payment in
from banks, which lowers the supply of reserves in the banking system,
and the funds rate rises.
What is the discount rate?
Banks also can borrow reserves directly from the Federal Reserve
Banks at their "discount windows," and the discount rate is
the rate that financially sound banks must pay for this "primary
Boards of Directors of the Reserve Banks set these rates, subject to
the review and determination of the Federal Reserve Board. ("Secondary
credit" is offered at higher interest rates and on more restrictive
terms to institutions that do not qualify for primary credit.) Since
January 2003, the discount rate has been set 100 basis points above the
funds rate target, though the difference between the two rates could
vary in principle. Setting the discount rate higher than the funds rate
is designed to keep banks from turning to this source before they have
exhausted other less expensive alternatives. At the same time, the (relatively)
easy availability of reserves at this rate effectively places a ceiling
on the funds rate.
What about foreign currency operations?
Purchases and sales of foreign
currency by the Fed are directed by the FOMC, acting in cooperation with
the Treasury, which has overall responsibility
for these operations. The Fed does not have targets, or desired levels,
for the exchange rate. Instead, the Fed gets involved to counter disorderly
movements in foreign exchange markets, such as speculative movements
that may disrupt the efficient functioning of these markets or of financial
markets in general. For example, during some periods of disorderly declines
in the dollar, the Fed has purchased dollars (sold foreign currency)
to absorb some of the selling pressure.
Intervention operations involving
dollars, whether initiated by the Fed, the Treasury, or by a foreign
authority, are not allowed to alter the
supply of bank reserves or the funds rate. The process of keeping intervention
from affecting reserves and the funds rate is called the "sterilization" of
exchange market operations. As such, these operations are not used as
a tool of monetary policy.