How the Fed Implements Monetary Policy | In Plain English

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The key tools of monetary policy are “administered rates” that the Federal Reserve sets: Interest on reserve balances; the Overnight Reverse Repurchase ... Home> InPlainEnglish-MakingSenseoftheFederalReserve> InPlainEnglishMenu Introduction HistoryoftheFed HistoryandPurposeoftheFed HistoryandResponsibilitiesoftheFed BoardofGovernors IntroductiontotheBoardofGovernors ChairoftheFederalReserveBoard FederalReserveBanks IntroductiontotheFederalReserveBanks TheFed'sRegionalStructure TheFederalReserveBanksandCurrency WhoOwnstheFederalReserveBanks? ReserveBankBoardofDirectors ReserveBanksandPolicy FederalOpenMarketCommittee IntroductiontotheFOMC TheFedandtheDualMandate TheFOMCConductsMonetaryPolicy TheFedImplementsMonetaryPolicy ExpansionaryandContractionaryPolicy GatheringData Supervision&Regulation SupervisionandRegulation:AnIntroduction SafetyandSoundness ConsumerProtection DiscountWindowLending TermAuctionFacility FinancialServices ProvidingFinancialServices ElectronicFormsofPayment Conclusion IndependenceandAccountability Summary Activities OnlineLearningModule Video MakingSenseoftheFederalReserve HowtheFedImplementsMonetaryPolicywithItsTools OncetheFederalOpenMarketCommittee(FOMC)adjuststhetargetrangeforthefederalfundsrate,theFederalReserveusesitsmonetarypolicytoolstoimplement,orcarryout,thenewstanceofpolicy.Inotherwords,theFedusesitstoolstoensurethatmarketinterestrates,especiallythefederalfundsrate,moveinthedirectionofthenewtargetrange.ThathelpssteertheeconomytowardtheFed’sdualmandategoals. Thekeytoolsofmonetarypolicyare“administeredrates”thattheFederalReservesets:Interestonreservebalances;theOvernightReverseRepurchaseAgreementFacility;andthediscountrate.Onemoretool,knownasopenmarketoperations,isneededtoensuretheseratesareeffective. InterestonReserveBalances:ThePrimaryNewMonetaryPolicyTool Interestonreservebalancesisjustthat—interestpaidonfundsthatbanksholdintheirreservebalanceaccountsattheirFederalReservebank.Becauseinterestonreservebalancesoffersbanksarisk-freeoption,itservesasa“reservationrate”—thelowestrateatwhichabankwillbewillingtolendoutitsfunds.Asaresult,thefederalfundsrateshouldnotfallbelowtheinterestonreservebalancesrate.Becausetheinterestonreservebalancesrateisanadministeredrate,theFedcansteerthefederalfundsratebyadjustingtheinterestonreservebalancesrate.Infact,interestonreservebalancesistheprimarytooltheFedusestoadjustthefederalfundsrate. OvernightReverseRepurchaseAgreementFacility:TheSupplementaryTool Noteveryfinancialinstitutionthatoperatesinthefederalfundsmarketcanearninterestonitsreservebalances.So,it’spossiblethatthefederalfundsratecouldfallbelowtheinterestonreservebalancesrate.Toprovidesupport,theFedofferstheovernightreverserepurchaseagreementfacilitytoabroadersetoflargefinancialinstitutions:Theycanearntheovernightreverserepurchaseagreementofferingrate,orONRRPrate,bydepositingfundswiththeFedatthisfacility.So,thissecondadministeredratehelpssetafloorforthefederalfundsrate. DiscountRate:SettingaCeilingfortheFederalFundsRate ThediscountrateistheinterestratechargedbytheFedforloansitmakesthroughtheFed’sdiscountwindow.BecausebankswillnotlikelyborrowatahigherratethantheycanborrowfromtheFed,thediscountrateactsasaceilingforthefederalfundsrate. Inshort,theFedadjuststwoadministeredrates,interestonreservebalancesandONRRP,tokeepthefederalfundsratewithinthetargetrangedeterminedbytheFOMC.AndtheFedadjuststhediscountratetoserveasaceiling.TheFedusuallyadjuststhethreeadministeredrates(interestonreservebalances,ONRRPanddiscount)bythesameamountandatthesametimesotheymoveupanddowntogether. …Andonemoretoolisnecessarytoensurethattheseadministeredratesareeffective. OpenMarketOperations:MaintainingAmpleReserves OpenmarketoperationsarethebuyingandsellingofgovernmentsecuritiesbytheFederalReserve.And,inparticular,whentheFedbuysasecurity,itpaysforitbycreditingtheappropriatebank’sreserveaccountattheFed.So,openmarketoperationschangethelevelofreservesinthebankingsystem.TheFed’sadministeredratesarethekeytoolsformonetarypolicywhenreservesinthebankingsystemareample.So,theFedusesopenmarketoperationsperiodicallytoensurethelevelofreservesinthebankingsystemremainlargeenoughsothatitcancontinuetoleanonitsadministeredratestoimplementmonetarypolicy. ForamorecompletediscussionoftheFed’smonetarypolicytools,readthePageOneEconomicsessay“TheFed’sNewMonetaryPolicyTools.” BACK: TheFOMCConductsMonetaryPolicy NEXT: ExpansionaryandContractionaryMonetaryPolicy

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