Understanding the Federal Reserve: How the Fed Maintains Interest Rates

After the Federal Reserve announced the first increase in its target benchmark interest rate in December since 2006, economists and market watchers immediately began speculating about the central banks’ next move. Will 2016 see a gradual lift-off in rates, or will the Fed hold steady?

For the layman, interpreting the Fed’s policy moves can be challenging. To foster a better understanding, we’ve previously looked at the Fed’s organization and mission and how the central bank implements interest rate changes in response to changes in the economic cycle.

Now let’s take a closer look at how the Fed maintains interest rate targets through one of the central bank’s key policy levers: open market operations (OMO).

As we noted previously, the Fed has a “dual mandate” of fostering maximum employment and stable prices in the U.S. economy. To achieve those ends, the Fed uses various monetary policy tools to affect the amount of money and credit in the economy, in part by influencing interest rates.

Media headlines may give the impression that the Fed “sets” interest rates, but that’s not exactly accurate. What the central bank does is establish a target for the federal funds rate, which is the interest rate banks charge to one another for overnight loans from their reserves. Then the Fed uses its monetary policy tools to nudge that short-term rate up or down.

In turn, changes in the federal funds rate will influence the broader interest rate environment. Short-term consumer rates tend to move together or are directly linked to the federal funds rate, which is why a change in the federal funds rate may lead to interest rate changes for mortgages, auto loans and savings accounts, as well.

The Fed’s monetary policy decisions are guided by the Federal Open Market Committee (FOMC), a panel composed of the central bank’s Board of Governors and five rotating members from the Fed’s regional banks. They meet several times each year to vote on the direction the Fed will take on monetary policy; their last such meeting was in March.

From 2007 until 2015, the Fed pursued a “loose money” policy, lowering its target federal funds rate range to an unusual near-zero level to encourage borrowing and other economic activity. With the small boost in the federal funds rates in December, the Fed is signaling a return to a more normal rate environment. It remains to be seen how rapidly the Fed will continue to raise rates in the months to come, if at all.

The FOMC’s toolbox includes a variety of tools for loosening and tightening monetary policy; among those tools, conventional OMO, or buying and selling government securities, is the most frequently deployed. Here’s how it works:

· Depository institutions in the U.S. banking system are required to hold a designated amount of funds in reserve to meet their depositors’ daily needs. Those reserves are held at the Fed. If a bank doesn’t have enough reserves, they need to borrow the difference from another bank. The interest rate banks charge for this overnight loan is the federal funds rate.

· To keep the federal funds rate within the target range, the Fed needs to manage the amount of reserves that are available by buying or selling Treasury debt or other government-agency securities in auction on the open market.

· These sales or purchases have an effect in the wider banking system: if the Fed buys securities, it serves to increase reserves; if it sells securities, reserves are decreased.

· If reserves shrink, that means banks have less ability to lend funds to one another — thus the federal funds rate they charge one another for short-term loans will increase. Increasing reserves has the opposite effect and will nudge the federal funds rate down.

Open-market operations are conducted as a matter of course, on an almost daily basis, as a way to keep the federal funds rate within the target range. You might think of it as roughly similar to how a driver makes subtle adjustments to the steering wheel of a car in motion to keep it between the lines and heading in the right direction.

Much of the time, that’s a reasonable analogy to describe the Fed’s activities. To steer policy decisions, the FOMC examines a wide range of economic indicators — such as data on inflation, job growth, consumer confidence, energy prices, market indices and more — to develop a sense of the economy’s trajectory. Then they craft and implement a set of monetary policy moves, including OMO, with the aim of moving the economy in the appropriate direction.

And in reality, it’s never easy to see around corners to determine where the economy is headed. There’s often vigorous debate within the Fed itself as to the best course, and that’s a reminder that there are no easy answers when it comes to managing interest rates and the money supply.

OMO isn’t the only monetary policy tool in the Fed’s toolbox. The central bank can also adjust reserve requirements for banks and influence the discount rate on loans from the Fed to depository institutions. But these tools are used far less frequently, so they’re not part of this discussion.

Open market operations are the most frequently used conventional tool for monetary policy. On the unconventional side, the Fed’s policy of “quantitative easing” or “QE” was a particularly expansionary form intervention, when large-scale asset purchases were undertaken to counteract the economic crisis of 2007–2009, with the goal of steering the economy away from a prolonged downturn. We’ll discuss QE in a future installment.