The term monetary policy refers to the actions that the Federal Reserve undertakes to influence the amount of money and credit in the U.S. economy. Changes to the amount of money and credit affect interest rates (the cost of credit) and the performance of the U.S. economy. To state this concept simply, if the cost of credit is reduced, more people and firms will borrow money and the economy will heat up.
The Fed has three main tools at its disposal to influence monetary policy:
Open-Market Operations - The Fed constantly buys and sells U.S. government securities in the financial markets, which in turn influences the level of reserves in the banking system. These decisions also affect the volume and the price of credit (interest rates). The term open market means that the Fed doesn't independently decide which securities dealers it will do business with on a particular day. Rather, the choice emerges from an open market where the various primary securities dealers compete. Open market operations are the most frequently employed tool of monetary policy.
Setting the Discount Rate - This is the interest rate that banks pay on short-term loans from a Federal Reserve Bank. The discount rate is usually lower than the federal funds rate, although they are closely related. The discount rate is important because it is a visible announcement of change in the Fed's monetary policy and it gives the rest of the market insight into the Fed's plans.
Setting Reserve Requirements - This is the amount of physical funds that depository institutions are required to hold in reserve against deposits in bank accounts. It determines how much money banks can create through loans and investments. Set by the Board of Governors, the reserve requirement is usually around 10%. This means that although a bank might hold $10 billion in deposits for all of its customers, the bank lends most of this money out and, therefore, doesn't have that $10 billion on hand. Furthermore, it would be too costly to hold $10 billion in coin and bills within the bank. Excess reserves are, therefore, held either as vault cash or in accounts with the district Federal Reserve Bank Therefore, the reserve requirements ensure that depository institutions maintain a minimum amount of physical funds in their reserves.
The Federal Funds Rate
The use of open-market operations is the most important tool that used to manipulate monetary policy. The Fed's goal in trading the securities is to affect the federal funds rate - the rate at which banks borrow reserves from each other. The Federal Open Market Committee (FOMC) sets a target for this rate, but not the actual rate itself (because it is determined by the open market). This is what news reports are referring to when they talk about the Fed lowering or raising interest rates.
All banks are subject to reserve requirements, but they frequently fall below requirements in carrying out of day-to-day business. To meet requirements they have to borrow from each other's reserves. This creates a market in reserve funds, with banks borrowing and lending as needed at the federal funds rate. Therefore, the federal funds rate is important because by increasing or decreasing it, over time, the Fed can impact practically every other interest rate charged by U.S. banks.
Remember, the end goals of monetary policy are sustainable economic growth, full employment and stable prices. Through monetary policy, therefore, the Fed attempts to tweak the economy to the right levels.
The Federal Reserve: The FOMC Rate Meeting
InvestingLearn about the tools the Fed uses to influence interest rates and general economic conditions.
Personal FinanceThe Federal Reserve can impact the cost of funds for banks and consequently for mortgage borrowers when maintaining economic stability.
Personal FinanceThe federal funds rate is the interest rate banks charge each other for overnight loans to meet their reserve requirements.
Personal FinanceThe federal discount rate is the rate at which eligible banks or other depository institutions can borrow funds from a Federal Reserve bank.
InsightsFind out how the Fed manages bank reserves and this contributes to a stable economy.
TradingCentral banks inject money into the banking system, and remove money from it, through monetary policy actions.
TradingThe Federal Open Market Committee is the branch of the Federal Reserve Board that determines monetary policy.
TradingThe Federal Reserve System is the central bank of the United States. It regulates monetary policy and supervises the nation’s banking system.