federal reserve

The Fed's monetary policy toolbox

Eight times a year, the august members of the Federal Reserve Board gather in a room to pore over economic data and debate where to set interest rates and how much credit to make available to the banking system.

The Fed's decisions on these two questions affect practically every aspect of your financial life, from your job market opportunities to the rates you pay on mortgages and car and consumer loans. They also affect the investment returns you receive from certificates of deposit, savings accounts and even equity holdings.

"The Federal Reserve has its hand on the controls of the economy more directly than anybody else," says Greg McBride, senior financial analyst for Bankrate.com. "In terms of pocketbook issues, the Federal Reserve is arguably more influential than the president. Unemployment, inflation, the pace of economic growth -- these are really the measuring sticks."

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Exactly how does the Fed carry out its two-pronged mission to spur economic growth while keeping inflation in check? A look inside the Fed's monetary policy toolbox reveals four primary levers of influence: interest rate targets, the level of liquidity, the buying and selling of securities and its public statements. Each one impacts either interest rates or credit availability or both, and is closely watched by investors and economists.

Interest rate targets

The most traditional Fed role is to set the federal funds rate, which banks pay to one another for overnight loans and which many consumer interest rates follow as a benchmark. The Fed can reach the desired federal funds rate in three ways: open market operations, the discount window and reserve requirements.

The phrase "open market operations" refers to the Fed practice of buying and selling Treasury securities to influence the supply of government debt and the cost of money. When the Fed wants to stimulate the economy, it buys bonds, thereby increasing the price and bringing down the interest rate on the securities. When the Fed wants to put the brakes on the economy, it sells Treasuries into the market to increase the supply, lower the price and raise interest rates, McBride says.

The Fed makes these transactions with primary dealers, the handful of securities firms authorized to trade in U.S. government securities with the Federal Reserve Bank of New York. Those dealers in turn transact with other banks and financial institutions so the Fed's actions ripple through the markets.

Open market operations

When the Fed easesWhen the Fed tightens
Fed buys government securities from a firm that deals in them.Fed sells government securities to a firm that deals in them.
It pays by crediting the account that the dealer's bank has at the Fed.It takes payment by debiting the account that the dealer's bank has at the Fed.
The bank in turn credits the dealer's account.The bank in turn debits the dealer's bank.
The banking system has more funds to lend.The banking system has fewer funds to lend.
Downward pressure on the federal funds rate -- the interest rate banks charge each other for overnight loans.Upward pressure on the federal funds rate.
Influences other interest rates in the economy -- which also go down.Other interest rates in the economy also rise as a result.
Gives the economy a boost.Slows the economy and curbs inflation.

Similarly, the Fed sets the discount rate, which moves up and down in tandem with the federal funds rate. Banks pay the discount rate when they borrow from the regional Federal Reserve banks. When the discount rate rises, banks pay more to borrow and tend to lend less, which boosts interest rates and reduces the available credit. When the discount rate falls, banks lend more freely, flooding the market with credit and causing consumer interest rates to fall, McBride says.

Discount window lending

Discount RateImpact on Economic ActivityMonetary Policy
Raising the discount rateSlows economic activity. The Fed is concerned about inflation.The Fed's goal is to check inflation.
Lowering the discount rateStimulates economic activity. The Fed is concerned about economic weakness.The Fed's goal is to spur economic growth.

Finally, the Fed can influence interest rates through reserve requirements, which refer to the amount of capital that banks must hold as security for their deposits. If the Fed increases the amount required as reserves, banks will be discouraged from lending, which tightens credit availability and increases rates. If the Fed lowers reserve requirements, the reverse occurs. Typically, the Fed refrains from changing reserve requirements to influence monetary policy, unless it has no other option available, because of the uncertainty it can introduce for banks.

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