What Is a Target Rate?
The target rate is the interest rate charged by one depository institution on an overnight sale of balances at the Federal Reserve to another depository institution, as determined by the Federal Open Market Committee (FOMC) of the Federal Reserve. A target range is sometimes designated by the FOMC along with the target rate during times of economic uncertainty. The target rate is often related to the risk-free rate in an economy.
The FOMC controls the target rate through open market operations (OMO), which involves the purchases and sales of securities such as U.S. Treasuries or mortgage-backed securities in the open market. It is considered a target interest rate because the actual value of the rate will depend on the supply and demand for overnight lending in the open market. However, because a bank demanding overnight reserves could borrow from the Fed itself at the discount window, the target rate tends to stay enforced.
Explaining the Target Rate
The 12 members of the Fed Open Market Committee meet for eight regularly scheduled meetings per year. During these meetings, the FOMC reviews economic and financial conditions and determines the federal funds target rate. A decline in the target rate could stimulate economic growth; however, too much activity can cause inflation pressures to build.
On the other hand, a rise in the rate limits economic growth and helps control inflation pressures; however, too much of an increase can stall economic growth or even cause it to decline. The FOMC generally seeks a target rate that will achieve the maximum rate of economic growth without sparking inflation.
The FOMC may schedule additional meetings as necessary to implement changes in the target federal funds rate. At any of the FOMC's meetings, the federal funds target rate may increase, decrease or remain unchanged depending on the economic conditions in the United States. A target is typically tied to a particular inflation level considered benign for an economy.
For instance, in the Janet Yellen era, the target rate for the federal funds rate was tied to 2% annual inflation. A change in the federal funds rate can affect other short-term interest rates, longer-term interest rates, foreign exchange rates, stock prices, the amount of money and credit in the economy, employment and the prices of goods and services.
Calculating the Target Rate
Central banks set the target rate using the Taylor Rule. This rule helps central bankers making recommendations that the Federal Reserve should raise interest rates when inflation is high or when employment exceeds full employment levels. Conversely, when inflation and employment levels are low, target interest rates should be decreased. Introduced by economist John Taylor, this formula was established to adjust and set prudent rates for the short-term stabilization of the economy, while still maintaining long-term growth. The rule is based on three factors:
- Targeted versus actual inflation levels
- Full employment versus actual employment levels
- The short-term interest rate appropriately consistent with full employment