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 additional 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.
The interest 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 market operations—that 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 falls.
When the Fed wants the funds rate to rise, it does the reverse, that is, it sells government securities. The Fed receives payment in reserves 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 credit.” The 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.