The Federal Reserve and Monetary Policy
Central banks, including the Federal Reserve, are responsible for monetary policy, which refers to the actions taken by central banks to manage the money supply, and, consequently, interest rates. These activities work toward achieving macroeconomic goals like stable prices, low unemployment, and economic growth. In contrast, fiscal policy is under the purview of the government, which uses taxation and government spending to influence a country’s economy, with the objective of promoting sustainable economic growth, manage inflation and stabilize business cycles. In a free market economy, interest rates along the entire yield curve are a function of market factors, and the Federal Reserve uses monetary policy tools to influence interest rates.
The Federal Reserve, through the Federal Open Market Committee (FOMC), adjusts the target range for the federal funds rate, and the Federal Reserve than uses its monetary policy tools to implement policy. These monetary policy tools aim to ensure market based interest rates, especially the federal funds rate, move in the direction of the established target range. These monetary policy tools include:
Open Market Operations: The Federal Reserve buys and sells government securities, and open market operations change the level of reserves in the banking system. The objective of open market operations is to ensure the level of reserves in the banking system supports monetary policy.
Interest on Reserve Balances: Interest is paid on those funds that banks hold in their accounts at their Federal Reserve bank. Since this interest on reserve balances gives banks a risk-free option, it is considered the lowest rate a bank would be willing to lend out its funds, and, consequently, the federal funds rate should not fall below the interest on reserve balances rate.
Revers Repurchase Agreements: The Federal Reserve provides overnight reverse repurchase agreements to a broad set of financial institutions because not every financial institution that operates in the federal funds market can earn interest on its reserve balances. Through reverse repurchase agreements these financial institutions can earn the overnight rate by depositing funds with the Federal Reserve through this facility, and this also assists in establishing a floor for the federal funds rate.
Discount Rate: The discount rate is the interest rate charged by the Federal Reserve for loans it makes through the discount window to banks. The discount rate can be viewed as a ceiling for the federal funds rate since banks are not likely to borrow at a higher rate than they could borrow from the Federal Reserve.
Monetary policy and fiscal policy are both critical for achieving economic goals, and the Federal Reserve, along with other central banks, use various tools to achieve monetary policy objectives.