Today we’re going to talk about a really important topic: what are the main tools that the Federal Reserve uses to influence the economy and how does it do it?
We will also learn the tools that the Fed uses in its new monetary policy and how they are different from their old way. Don’t worry if you’re not familiar with economics, because I am going to break it down step by step.
So, first things first, what is the Federal Reserve? Well, it’s the central bank of the United States and to put it simply, The Federal Reserve (the Fed) is like a bank for the U.S. government.
If you look at the Federal Reserve website, it says “One of the most important functions of the Fed is to promote economic stability using monetary policy. The Fed’s goals for monetary policy, as defined by Congress, are to promote maximum employment and price stability.” This means the highest level of employment that the US economy can sustain while maintaining a stable inflation rate of around 2%.
So how does the Fed control the economy?
The Fed has some tools to control the economy, these are monetary policy tools. Imagine the economy is like a car. If it’s going too fast and might crash, then the Fed can step on the brakes. If it’s too slow, they can press the gas pedal.
The FOMC is the money boss
So let’s understand how the Fed works, The Federal Open Market Committee, or the FOMC is like the money boss of the Federal Reserve. They meet in Washington, D.C., eight times a year to talk about the economy. They look at economic data and statistics, talk to economists, and decide how much interest banks should charge each other.
This interest is called the federal funds rate. Fed funds rate is the banks’ overnight lending and borrowing rate from each other. This rate matters because it affects how much regular people pay for things like houses and cars. If it’s high, things are a bit more expensive. If it’s low, things are more affordable.
Let’s understand it step by step, Banks have a place where they put some of their money, called the Federal Reserve. They earn interest on it. Sometimes, one bank has extra money and another needs some to do their everyday stuff. So, the bank with extra money can lend it to the one that needs it. The important part is that the interest rate for this lending is not decided by the big boss or the Fed but by the banks themselves. They agree on a fair rate and it is thus market-determined.
So how does the Fed steer this key interest rate in the target range set up by FOMC?
The Fed uses its two administered rates – the first is the interest on reserve balance and the second is the rate on reverse purchase agreement. These are their main monetary tools to control the Federal funds rate in the current times.
According to the Fed’s chair, Jeremy Powell, “The Federal Reserve sets two overnight interest rates: the interest rate paid on banks’ reserve balances and the rate on our reverse repurchase agreements. We use these two administered rates to keep a market-determined rate, the federal funds rate, within a target range set by the FOMC.”
When the FOMC wants the fed funds rate to go up, the Fed moves the interest on the reserve balance up. This rate sets the lowest interest rate banks are willing to accept when lending out their money to anyone else. Since banks can also earn this interest by depositing their money at the Federal Reserve and keeping money with the Fed is a safe way to earn money, banks prefer to do this rather than lend it at a lower rate to another bank.
This acts as a floor for the Federal funds rate, which means the banks will not accept any lower interest rate than this to lend money to one another for a short term.
Another important concept to understand here is called “arbitrage,” which is like making a profit by buying low and selling high. So let’s say the federal funds rate is 5.5%, and the Fed pays 6% for deposits to be kept at Fed, banks can borrow at 5.5% from other banks and then deposit at 6% to make a profit.
This pushes the federal funds rate up until it’s close to the interest on reserve balances rate (6%). Similar to the interest on reserve balance which is mainly for commercial banks, the Fed also has other tools, like the “Overnight Reverse Repurchase Agreement Facility,” which is the interest other broader financial institutions can earn by keeping money at the Fed. Thus, it serves the same purpose as the interest on reserve balance and sets a floor for the federal funds rate, which means the federal funds rate won’t go below this.
The other tool the Fed uses is the Discount Window. Because banks will not likely borrow at a higher rate than they can borrow from the Fed, this acts as a ceiling. It is set higher than the interest on reserve balances rate and the overnight reverse repurchase agreement rate.
So these are two tools that the Fed is now using in the ample reserves case.
The Fed’s tools before the 2008 crisis
The Fed used to use this tool called Open Market Operations as its primary tool, where it bought treasury securities to pump money into the economy. However, after the 2008 financial crisis, it has ample reserves that it only buys government securities to make sure the reserves remain ample in the banking system. So, it uses open market operations only as a supplement tool.
So how does the FOMC decide on the target interest rate?
Economic data on inflation and unemployment helps the FOMC decide its target interest rate. Over the years, FOMC has been changing this Federal funds rate target range up and down to help the economy. Think of it like a volume knob on your music player.
When the economy was in trouble after the 2008 financial crisis, the Fed turned the volume to almost zero to help it get better in 2015.
Then, when the COVID-19 pandemic happened, they quickly turned the volume back down to almost zero to help the economy during that tough time.
Most recently, since last June 2022, the Fed has been raising the interest rate to control inflation. As of today, the target range for the Federal funds rate is between 5.25 to 5.50%.
So, you can think of the Fed as a DJ for the economy, adjusting the volume to keep things running smoothly.
