1. The Federal Reserve: Introduction
  2. The Federal Reserve: What Is The Fed?
  3. The Federal Reserve: Duties
  4. The Federal Reserve: Monetary Policy
  5. The Federal Reserve: The FOMC Rate Meeting
  6. The Federal Reserve: Conclusion

The Federal Open Market Committee has eight scheduled meetings each year to determine if the federal funds rate target should be adjusted. Before each meeting, FOMC members receive the "Green Book," which contains the Federal Reserve Board (FRB) staff forecasts for the U.S. economy; the "Blue Book," which presents the Board staff's monetary policy analysis; and the ”Beige Book," which includes a discussion of regional economic conditions prepared by each Reserve Bank. 

When the FOMC meets, it decides whether to lower, raise or maintain its target for the federal funds rate. The It also decides on the discount rate. The reason we say that the FOMC sets the target for the rate is because the actual rate is determined by market forces. The Fed does its best to influence open-market operations, but many other factors contribute to what the actual rate ends up being.

A good example of this phenomenon occurs during the holiday season. During this spending season, consumers have an increased demand for cash, and banks draw down on their reserves. This places a higher demand on the overnight reserve market – which increases the federal funds rate. Keep in mind, when you hear there is a change in the federal funds rate, it’s actually a change in the Fed's target. (For related reading, see What is the Relationship Between the Federal Funds, Prime and LIBOR Rates?)

If the FOMC wants to increase economic growth, it reduces the target fed funds rate. Conversely, if it wants to slow down the economy, it increases the target rate. The Fed tries to sustain steady growth, without the economy overheating. If the economy is growing too fast, we end up with inflation. If the economy slows down too much, we end up in a recession. (For more, see The Impact of a Fed Interest Rate Hike.)

Sometimes the FOMC maintains rates at current levels but warns that a possible policy change could occur in the near future. This warning is referred to as the bias. The means that the Fed might think that rates are fine for now, but that there is a considerable threat that economic conditions could warrant a rate change soon. The Fed will issue an easing bias if it thinks the lowering of rates is imminent. Conversely, it will adopt a bias towards tightening if it feels that rates might rise in the future. (For more, see How Much Influence Does the Fed Have?)

Why It Works 

If the target rate increases, the FOMC sells securities. If the FOMC reduces the target rate, it buys securities. For example, when the Fed buys securities, it essentially creates new money to do so. This increases the supply of reserves in the market. If the Fed buys a government security, it issues the seller a check, which the seller deposits in his or her bank. This check is then credited against the bank's reserve requirement. As a result, the bank has a greater supply of reserves, and doesn't need to borrow money overnight in the reserves market. Therefore, federal funds rate is reduced. Of course, when the Fed sells securities, it reduces reserves at the banks of purchasers, which makes it more likely that the bank will engage in overnight borrowing, and increase the federal funds rate. (For more, see Why do Commercial Banks Borrow from the Federal Reserve?)

Keep in mind that reducing the target rate means the Fed is putting more money into the economy. This makes it cheaper to get a mortgage or buy a car, for example, which helps to boost the economy. Interest rates are related, so if banks have to pay less to borrow money themselves, the cost of a loan is reduced. (For related reading, see How the Federal Reserve Affects Mortgage Rates.)

 


The Federal Reserve: Conclusion
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