The Federal Reserve’s Federal Open Market Committee (FOMC) met on December 14th to discuss the state of the economy, and with that the status of the interest rate. The Fed agreed to an interest rate hike for the second time since the Great Recession, implying solid economic recovery. The FOMC will increase the interest rate to .5% - .75%.
All this talk about the Federal Reserve (the Fed) increasing interest rates leads many to question, “How exactly do they do this?” The Fed can change rates in several different ways, using conventional and unconventional monetary policy. This article will discuss conventional policy tools, while the next issue will discuss unconventional tools.
It is first important to understand that the federal funds interest rate is simply the price at which banks lend to each other and to the open market. There are different interest rates for different purposes, yet the one everyone is talking about is the federal funds rate, or the rate that banks lend to each other overnight. It is also important to bear in mind that supply and demand are the sole drivers of these policies. If demand increases then prices rise, while if supply increases then prices fall, and vice versa. In controlling the money supply, the Fed changes the price that banks lend to each other and the open market.
The federal funds rate is important because it carries on to the open market. When the federal funds rate increases, banks are less incentivized to lend to the public at lower rates. Therefore, they will increase their lending rate, making loans more expensive. Higher interest rates on loans makes investing more expensive and thus contracts the economy.
Conventional monetary policy is primarily implemented through open market operations, but can also be implemented through the discount window and reserve requirements.
The Fed primarily conducts open market operations by buying and selling securities to banks for a period of one day. These are called repurchase agreements (repos) if the Fed is buying securities, and reverse repos if the Fed is selling securities. When the Fed conducts repos, they are temporarily buying securities from banks with the intention of selling them back the next day with minimal interest. In doing this, the Fed temporarily increases the money supply. When the Fed plans to increase the federal funds rate for an extended period of time, they conduct reverse repos for many days in a row. In order to lower interest rates and stimulate the economy, the Fed reverses these policies, which decreases the price of loans and increases investment.
The Fed can also conduct policy through the discount window by directly lending to banks. However, the discount window is usually not used for monetary policy as it is intended to provide funds for banks when those funds cannot be found in the federal funds market. When the Fed makes loans, it increases the money supply. If the Fed instead needed to provide funds to banks without conducting monetary policy, they conduct open market operations to counteract the effects of the discount window. This is called sterilization.
Finally, reserve requirements can be used to directly control the money supply. The Fed currently requires banks to hold a specific proportion of their deposits in cash, instead of lending it out. This is essentially keeping money on hand, either on reserve at the Fed or literally in the vault. They do this so banks have cash in the case of an unexpected withdrawal. The Fed can implement monetary policy by changing the proportion of required reserves. To decrease the money supply, they increase this ratio, forcing banks to reduce lending in order to hold more cash. As discussed earlier, when the supply of money shrinks, lending between banks becomes more expensive, which increases the federal funds rate. Although theoretically, the Fed can use reserve requirements to conduct monetary policy, minimal changes can lead to major fluctuations in the money supply. Therefore, they do not usually conduct policy through reserve requirements.