The Fed and Monetary Policy

The Fed’s primary mission is to ensure that enough money and credit are available to sustain economic growth without inflation. If there is an indication that inflation is threatening our purchasing power, the Fed may need to slow the growth of the money supply. It does this by using three tools—the discount rate, reserve requirements and, most important, open market operations.

Responsibility for open market operations rests with the Federal Open Market Committee (FOMC). The committee, consisting of the seven-member Board of Governors and the 12 Reserve Bank presidents, meets eight times a year. The governors and the president of the New York Fed are permanent voting members; the other Reserve Bank presidents fill the four remaining voting-member positions in rotation, although the nonvoting members participate fully in deliberations. Reserve Bank boards of directors, research departments and regional business leaders contribute grassroots information and insight that are used to formulate monetary policy. The Reserve Bank boards recommend changes in the discount rate to the Board of Governors, and the Board of Governors has jurisdiction over reserve requirements. In this way, both the public and the private sectors contribute to these decisions.

Open Market Operations

The Fed’s most frequently used monetary policy tool is open market operations—the buying and selling of U.S. Government securities on the open market for the purpose of influencing short-term interest rates and the growth of the money and credit aggregates. Once the FOMC has established policy, the Federal Reserve Bank of New York implements the Fed’s open market operations daily. Whenever an increase in the growth rate of the money supply and credit is needed, or if downward pressure on short-term interest rates is desired, the Fed buys securities from brokers or dealers. Each transaction is handled electronically. Dealers send securities to the Fed over an electronic network, and the Fed adds money to the reserve accounts of the banks of the brokers or dealers. The banks, in turn, credit the accounts of the brokers and dealers, thereby increasing the amount of money and credit available in the market.

Whenever it is necessary to slow the growth of money and credit, this process works in reverse. The Fed sends securities to brokers and dealers electronically and takes payment by debiting the accounts of banks with which the brokers and dealers do business. These reserves leave the banking system, thereby reducing the money supply and curtailing the expansion of credit.

The Discount Rate

The discount rate is the interest rate the Federal Reserve Banks charge financial institutions for short-term loans of reserves. A change in the discount rate can inhibit or encourage financial institutions’ lending and investment activities by sending a signal about the Fed’s goals and by indirectly influencing the interest rates banks pay depositors for funds and at which banks offer loans. The discount rate is changed infrequently.

The Reserve Requirement

The reserve requirement is the percentage of deposits in demand deposit accounts that financial institutions must set aside and hold in reserve. If the Fed raises the reserve requirement, banks have less money to lend, which restrains the growth of the money supply. On the other hand, if the Fed lowers the reserve requirement, banks have more money to lend and the money supply increases. The Fed changes the reserve requirement relatively infrequently. In fact, it is the least-used monetary policy tool because changes in the reserve requirement significantly affect financial institution operations. Reserve requirement changes are seen as a sign that monetary policy has swung strongly in a new direction.

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