How the Fed Implements Monetary Policy Notes

Introduction to the Federal Reserve and Monetary Policy

  • How the Federal Reserve (The Fed) conducts monetary policy to achieve:

    • Price Stability

    • Maximum Employment

The Fed’s Toolbox

  • Dual Mandate of the Federal Reserve:

    • The responsibility to use monetary policy to promote:

    • Maximum Employment:

      • Defined as the highest level of employment that can be sustained while maintaining low and stable inflation.

      • The Fed assesses shortfalls of employment from the maximum level to guide policy decisions.

    • Price Stability:

      • Characterized by a low and stable rate of inflation, maintained over an extended period.

      • The goal is to achieve an average inflation rate of 2% over time.

The Federal Funds Rate (FFR)

  • Definition:

    • The FFR is the interest rate at which banks lend reserves to each other.

    • Banks maintain cash in checking accounts at the Fed, known as reserve balance accounts.

    • A federal funds transaction involves the transfer of funds between banks' reserve accounts at the Fed.

  • Functionality:

    • The Fed sets a target range for the FFR.

    • This influences other interest rates and the economic behavior of consumers and producers.

FOMC Target Range (2015-2020)

  • Setting Parameters:

    • The target range for the FFR set by the FOMC is commonly 25 basis points (0.25%) wide.

Ensuring Target Range Transmission

  • Implementation Tactics:

    • The Fed employs monetary policy implementation tools to keep the FFR within the target range.

Policy Implementation Tools

  1. Interest on Reserve Balances (IORB)

  2. Overnight Reverse Repurchase Agreement (ON RRP) Facility

  3. Discount Window

  4. Open Market Operations

  • Administered Rates:

    • IORB rate

    • ON RRP rate

    • Discount Rate

Tool #1: Interest on Reserve Balances (IORB)

  • Primary Tool:

    • Banks earn interest from the Fed on their declining reserve balances.

    • This interest rate helps steer the FFR into the FOMC’s target range.

  • Concepts of IORB:

    1. Reservation Rate:

    • Defined as the lowest interest rate a bank would accept for lending out its funds.

    1. Arbitrage:

    • It refers to the simultaneous purchase and sale of assets (or funds) to profit from price differences.

  • Bank Options with Excess Funds:

    • Banks can:

    1. Deposit excess funds at the Fed to earn the IORB rate.

    2. Lend these funds in the federal funds market for the FFR.

    3. Invest in Treasury Bills for a specific TB rate.

  • Interaction between IORB and Market Rates:

    • If the IORB rate exceeds market rates, banks choose IORB due to its risk-free nature.

Example and Market Dynamics

  • Illustrative Example of Arbitrage in Federal Funds Market:

    • 2.0% FFR vs. 2.5% IORB:

    • Banks will profit by borrowing funds at 2.0% and depositing them at 2.5%, yielding a profit of 50 basis points until the market equilibrates.

  • When IORB is higher than market rates,

    • Analysis of interactions in banking decisions can lead to zero profits due to competitive behaviors in the federal funds market.

The Influence of FOMC on IORB

  • The Fed adjusts the IORB based on the FOMC's target for the FFR to move the actual federal funds rate into the target range:

    • Increase in FFR Target Range:

    • The Fed raises the IORB, leading to a rise in the FFR.

    • Decrease in FFR Target Range:

    • The Fed lowers the IORB, prompting a decrease in FFR.

Tool #2: Overnight Reverse Repurchase Agreement (ON RRP) Facility

  • Function:

    • Acts as a supplemental tool by providing a rate that acts as a reservation rate for a vast array of financial institutions.

    • Sets a floor on the federal funds rate.

Tool #3: Discount Window

  • Definition:

    • A Federal Reserve service allowing banks to borrow funds at the discount rate (set above the FOMC target range).

    • Functions as a ceiling for the federal funds rate.

Tool #4: Open Market Operations

  • Definition:

    • Buying and selling government securities periodically to maintain sufficient reserves in the banking system.

  • Mechanics:

    • The Fed can influence the FFR by adjusting the supply of reserves through these operations.

Adjustments in FFR

  • The Fed lowers the FFR by decreasing administered rates (IORB and ON RRP).

  • The Fed raises the FFR by increasing these rates.

Economic Scenarios and Fed Responses

  • Weakening Economy:

    • Employment falls below maximum employment with steady inflation around 2%:

    • FOMC decreases FFR target range.

    • Lower borrowing costs lead to increased spending and investment, boosting production and employment.

  • Rising Inflation:

    • Inflation surpasses 2% with low unemployment:

    • FOMC increases FFR target range.

    • Higher borrowing costs discourage spending and lessen inflationary pressures.

Tool Summaries

  • IORB:

    • Interest paid on bank reserves at the Fed; primary tool influencing FFR.

  • ON RRP:

    • Allows institutions to deposit funds at the Fed, establishing an interest floor.

  • Discount Window:

    • Federal Reserve lending to banks that sets a ceiling on FFR.

  • Open Market Operations:

    • Vital for ensuring adequate reserves in the banking system.

Review Questions

  • What are the Fed’s dual mandate goals?

  • What does it mean to conduct monetary policy?

  • What does it mean to implement monetary policy?

  • What is the Fed’s primary tool for implementing monetary policy?

  • How does the interest on reserve balances rate serve as a reservation rate?

  • Provide an example of arbitrage between the federal funds market and interest on reserve balances.

  • How does arbitrage maintain the FFR relative to IORB?

  • What is the discount rate and how does it act as a ceiling for the FFR?

  • How does the Fed use open market operations to ensure reserves remain ample?

  • What would the FOMC do if the economy is in a recession and not meeting its maximum employment and price stability dual mandate?