Monetary Policy - The Economic Lowdown Video Series

The Federal Reserve, “the Fed,” is the central bank of the United States. One of its important functions is to promote a strong U.S. economy. In fact, congress has given the Fed two main goals: maximum employment and price stability. These goals are often referred to as the Fed’s “dual mandate.” The Fed uses monetary policy to move the economy toward these goals.

Now, price stability doesn’t mean that prices never change. It means that the inflation rate remains low and stable over the longer run. The Fed’s policymaking group, the Federal Open Market Committee, often referred to as the FOMC, has stated that it would like inflation to average 2 percent over time.

Maximum employment is the highest level of employment that the economy can sustain over time. The FOMC determines how the labor market is doing relative to how it could potentially be doing at maximum employment. To do this, it looks at a wide range of economic indicators, including the unemployment rate.

So how does the Fed try to achieve its dual mandate? The Fed sets monetary policy to start a chain of events in the economy. Here’s how it works: First the FOMC meets. It has 8 regularly scheduled meetings a year. At these meetings, the committee looks at data on current economic conditions —what is trending up and what is trending down—and how the economy is likely to change going forward. Based on that information, the FOMC makes a monetary policy decision. Specifically, it decides what is the appropriate target range for the federal funds rate, which is a short-term interest rate.

With the target range set, the Fed then uses its policy tools to steer the federal funds rate into this target range. When the federal funds rate moves, it affects other interest rates, and interest rates affect overall financial conditions. These financial conditions in turn influence how households and businesses decide to spend and invest. And those choices in turn affect employment and prices.

So here’s how the chain reaction might work. Let’s say the FOMC thinks the economy is overheating, with unemployment very low and inflation too high for a period of time. To nudge the economy on the right track, it’ll move the target range for the federal funds rate up. Then the Fed will use its policy tools to steer the federal funds rate into the target range, which encourages other interest rates to move up. When interest rates are higher, households and businesses tend to spend and invest less and save more. When spending declines, there is less demand for workers and prices tend to decline.

Now let’s say the FOMC thinks the economy is weakening, with employment falling short of its maximum level or inflation declining below target. In this case the committee may move the target range for the federal funds rate down and the Fed would put its tools to work to encourage market interest rates to move down. With lower interest rates, and easier financial conditions more broadly, households and businesses will likely spend and invest more and save less. When spending increases, there is more demand for workers and upward pressure on prices.”

These are the linkages that the FOMC has in its mind as it chooses the appropriate target range for the federal funds rate to move the economy toward the Fed’s dual mandate.

But how does the Fed ensure that the federal funds rate actually moves into the target range? Join us for Part 2 to learn about two important interest rates the Fed uses to implement the FOMC’s policy setting.

When the Federal Open Market Committee, the FOMC, conducts monetary policy, it is taking actions to manage financial conditions that encourage the economy to move towards the Fed’s goals of maximum employment and price stability. It does so by setting a target range for the federal funds rate.

But wait, what is the federal funds rate? It is easiest to think about it as a short-term interest rate that banks charge when they lend funds to another bank.

Let’s make sure we get what this important interest rate is. Banks hold funds in accounts at the Fed called reserve balance accounts. When Bank A needs to borrow funds, it might borrow them from Bank B if Bank B has extra reserve balances. When banks borrow from each other like this, it’s typically just overnight. The next day, Bank A returns the funds plus a bit of interest to Bank B. These transactions occur in the federal funds market, and the interest rate banks agree to is the federal funds rate.

On any given day, there are many transactions in the federal funds market, and they settle at slightly different federal funds rates.  The effective federal funds rate, measures the median rate of all these transactions. The FOMC sets the target range for where it wants this effective federal funds rate to be or, in other words, a majority of the transactions should fall within the target range. So how does the Fed make sure this happens? It uses one of the interest rates that it sets called “interest on reserve balances.” As the name implies, the Federal Reserve pays interest on the reserve balances banks hold in their accounts at their regional Federal Reserve Bank.

For banks, their reserve balance account offers a safe, risk-free, overnight investment option. If they have excess funds, they can always deposit them into their reserve balance account and earn interest, just like you can do with a savings account.

But the interest rate on reserve balances is more than an opportunity for banks to earn interest. This rate is an important tool that the Fed uses to steer the federal funds rate into the FOMC’s target range. And two economic concepts help explain how this process works: reservation rate and arbitrage. Join us in Part 3 to find out what those concepts mean and how they work.

In the last episode you learned that banks can earn interest on their deposits at their Federal Reserve Bank, or they can earn interest by lending to other banks in the federal funds market. When banks hold funds in reserve balance accounts at the Fed, they earn the interest on reserve balances rate. When banks lend funds to other banks from their reserve balance accounts, they earn the federal funds rate.

So, when banks have excess funds, they look across these two options to decide the best place to invest them. Because of this choice, the Fed uses the interest on reserve balances rate to steer the federal funds rate into the FOMC’s target range. The Fed knows the interest on reserve balances rate will steer the federal funds rate into the target range because of two economic forces, reservation rate and arbitrage.  Let’s see how each of these forces work.

The first thing to understand is what is a reservation rate. A reservation rate is the lowest rate of return that a bank is willing to accept for lending out its funds. Because a bank earns interest on the funds in its reserve balance account, there’s really no need for it to lend these monies out for anything less than what it can get from the Fed.

Let’s look at an example. Suppose a bank has only two options to invest its funds overnight. Option one is to deposit its excess funds in its reserve balance account and earn the interest on reserve balances rate. And option two is to lend its excess funds to another bank in the federal funds market and earn the negotiated federal funds rate. These are both low-risk options for the bank to earn interest overnight.

What’s the choice the bank is most likely to make? It depends on the interest rates.

What if the interest on reserve balances rate is 2.5%, while the federal funds rate is around 2%? Well, the bank will most likely choose the first options. The bank will deposit its funds at the Fed and earn the higher rate.

In fact, because banks seek the best return for their money across similar risk and maturity options, they are unlikely to lend or invest in an overnight asset for less than it can earn by depositing at its Federal Reserve Bank. So, for banks, interest on reserve balances serves as a reservation rate -- the lowest rate of return that banks are willing to accept for lending out funds.

Now, how does the interest on reserve balances rate steer the federal funds rate? Meaning, in this case, help to pull the federal funds rate up? The answer has to do with arbitrage. Arbitrage here is the simultaneous purchase and sale of funds in order to profit from a difference in interest rates. Arbitrage ensures that the federal funds rate will stay near to the interest on reserve balances rate because arbitrage will close the gap between the two rates.

Let’s go back to our example:  Recall option one has the interest on reserve balances rate at 2.5 percent and option two has the federal funds rate at 2 percent, the federal funds rate will be pulled up. Why? Well, in this case, banks will borrow funds in the federal funds market at a 2% rate and immediately deposit those same funds at the Fed and earn 2.5% rate. This action is arbitrage. The profit is 50 basis points, or ½ percentage point, for every dollar invested.

Now, any bank can do this—borrow in the federal funds market and deposit those funds at the Fed to earn a profit.

When more and more banks want to borrow in the federal funds market, the competition for loans increases and lenders will to start charge a bit more. That is, the federal funds rate will start to rise. In fact, arbitrage should continue until the federal funds rate rises to a level that banks no longer have the opportunity to profit.

So, arbitrage ensures that the federal funds rate never falls too far below the interest on reserve balances rate. And arbitrage would also ensure that the federal funds rate would never be too far above the interest on reserve balances rate.

Given that these economic concepts are always working in the background, the Fed can effectively use interest on reserve balances to ensure market rates move as desired.

For example, When the FOMC increases the target range, the Fed raises the interest on reserve balances rate.  Arbitrage kicks in to make sure the federal funds rate moves up toward the interest on reserve balances rate and within the range.  Similarly, when the FOMC lowers the target range for the federal funds rate, the Fed lowers the interest on reserve balances rate, which encourages the federal funds rate to move down into the new target range.

Now we know how the Fed is able to steer the federal funds rate into the FOMC’s target range.  Join us for Part 4 to learn how the Fed decides to set the policy rate to help move the economy toward its congressionally assigned dual mandate: maximum employment and price stability.

In part 3 we learned how the interest on reserve balances rate acts as a reservation rate for banks, and how arbitrage steers the federal funds rate into the FOMC’s target range. Now let’s turn to how the FOMC decides on the appropriate level for the target range.

It might be easiest to think about a situation where the economy seems to be weakening.

Suppose the FOMC is meeting and looking at the economic data. After a thorough review, the FOMC determines that employment or inflation is too low. And, economic data suggest the economy may weaken further. In this case, the FOMC might decide to use “expansionary" or “accommodative” monetary policy to provide stimulus for the economy. That is, the FOMC could lower its target range for the federal funds rate and the Fed would decrease the interest on reserve balances rate. For example, if the FOMC lowers the target range by 25 basis points—which is ¼ percent, then the Fed is likely to also lower the interest on reserve balances rate by 25 basis points.

Because of the economic concepts of reservation rate and arbitrage, the lowering of the interest on reserves balances rate pulls the interest rate that banks charge each other in the federal funds market down. When the federal funds rate declines, it starts a chain reaction: other interest rates tend to follow, which then affects overall financial conditions. When interest rates decline, the cost of borrowing money declines, which encourages households to increase spending and businesses to increase investment. As spending increases, so will production, and businesses are likely to hire additional employees and spend more on other resources. As these increases in spending ripple through the economy, unemployment decreases, moving the unemployment rate down toward its full employment level, and inflation possibly moves up.

So, when the economy is stalling, the Fed’s monetary policy actions, both lowering the target range for the federal funds rate and reducing the interest on reserve balances rate can be effective for moving the economy back towards maximum employment and price stability.

So, by increasing the target range for the federal funds rate, and increasing the interest on reserve balances rate, the Fed can move the economy back toward maximum employment and price stability.

To conclude our discussion about monetary policy, let’s sum up with a few key points. The Federal Reserve has a dual mandate from congress to promote maximum employment and price stability. The Fed moves the economy toward these goals by setting a target range for the federal funds rate. The Fed uses interest on reserve balances as its primary policy tool to steer the federal funds rate into the target range. The setting of monetary policy affects other interest rates, which ultimately influence broader financial conditions. These factors affect consumer and producer decisions and ultimately the level of employment and inflation, which promote a strong U.S. economy.

So now you know what it means when you hear news reports that the Fed raised or lowered interest rates. It is really that the FOMC adjusted its target range and, because of economic concepts like reservation rate and arbitrage, market interest rates moved appropriately, and this affected consumer and business decisions. This is all done to move the economy forward in a healthy manner to maximize employment and keeping prices stable.