How the Fed Seeks to Influence Interest Rates

July 11, 2017

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It mostly comes down to one number.

That number is the federal funds rate, the interest rate financial institutions charge one another for overnight loans made from balances held at Federal Reserve banks.

But when the Fed's policy-setting Federal Open Market Committee (FOMC) decides to adjust the fed funds rate, not all interest rates throughout the economy change instantaneously. Rather, monetary policy is "transmitted," through various channels, to an array of very short-term interest rates and financial market prices. These changes, in turn, ripple through the financial system to influence rates on all kinds of loans to consumers and businesses.

Simply put, when interest rates rise, people tend to borrow less and prices tend to stabilize. When interest rates fall, people and businesses tend to borrow and spend more, which can stimulate the economy.

The transmission machinery changed with the 2007–08 financial crisis

Today, the FOMC moves the federal funds rate into its target range mainly by adjusting the interest rate on money—reserves—that banks and other depository institutions keep in accounts at the Fed, according to the FOMC's Policy Normalization Principles and Plans.

The Fed also employs a backup tool known as overnight reverse repurchase agreements. But changing the interest rate on reserves is the main means of adjusting the federal funds rate. At the Atlanta Fed, most of the roughly 1,500 depository institutions in the Sixth District (Alabama, Florida, Georgia, and parts of Louisiana, Mississippi, and Tennessee) hold reserves with the Atlanta Fed.

This tool, the interest rate on required and excess reserves, is relatively new. The Fed began paying interest on reserves in 2008 to help nurse the economy and financial system through the financial crisis. The interest rate on reserves—those the Fed requires institutions to maintain as well as "excess" reserves that institutions choose to keep—stands at 1 percent. In March 2015, the FOMC declared it would set the interest rate on reserves equal to the top of the target range for the federal funds rate. Therefore, the FOMC has raised the rate on reserves along with each move to increase the federal funds rate.

The FOMC hiked the rate on reserves from 0.25 percent in December 2008 to 0.50 percent in December 2015, then to 0.75 percent a year later, to 1 percent in March of this year, and finally to 1.25 percent in June.

The opportunity cost of interbank lending influences the fed funds rate

But how does the shifting of interest rates on reserves ultimately influence rates on consumer and business loans?

Increasing the rate on reserves puts powerful upward pressure on short-term interest rates throughout the financial system, explains Paula Tkac, an Atlanta Fed vice president and senior economist who specializes in financial markets. That pressure results from what economists call "opportunity cost."

Opportunity cost represents the value of the alternative one does not choose. So in this case, if a bank can earn 1 percent for simply parking its money risk-free at the Fed, then surely it would charge more than 1 percent to lend it to another financial institution overnight (a fed funds transaction).

Currently, the banking system holds abundant reserves. If there were no interest paid on these reserves, banks might be willing to lend these funds at very low interest rates to earn some return. But by paying banks interest on the reserves, the Fed influences the banks' opportunity cost of lending these funds out overnight. This also gives the Fed the ability to nudge the federal funds rate up to what it views as the right level.

Because financial institutions and markets are so interconnected, Tkac explains, by tweaking the future path of short-term rates, the Fed effectively changes a central ingredient in the recipe lenders and investors use to formulate longer-term rates.

"If the FOMC signaled it was likely to increase the fed funds target rate faster than investors were currently expecting, long-term Treasury rates would likely increase," Tkac says. "Conversely, a slowdown in the pace of expected fed funds target increases would likely lower long-term Treasury rates."

In turn, rates on other, riskier long-term securities—corporate and mortgage-backed bonds, say—tend to move in step with rates on Treasuries. When investors or lenders consider the rate of return they need for tying their money up for a longer time, they begin that calculation with a baseline forecast of where they think the FOMC will choose to set short-term rates over that period.

The role of large-scale asset purchases in policy transmission

Before the financial crisis, the FOMC's primary tool was open market operations—the buying and selling of government securities. The open market desk at the Federal Reserve Bank of New York buys securities to increase the level of reserves held by banks—"pumping" money into the economy—or sells securities to remove reserves—"draining" money from the economy.

A key reason open market operations could move short-term interbank interest rates in the precrisis era was that the quantity of reserves in the banking system was quite low. When reserves are scarce, small changes in the supply of reserves brought about by normal open market operations can move the fed funds rate.

Large-scale asset purchases— what some people call "quantitative easing"— changed all that. From 2008 through 2014, the Fed conducted a large quantity of large-scale asset purchases of longer-term securities issued by the U.S. government or guaranteed by government-sponsored agencies such as the Federal National Mortgage Association, or Fannie Mae, and the Federal Home Loan Mortgage Corporation, or Freddie Mac.

The purchases were large enough that the selling institutions inevitably channeled some of the proceeds into reserves, where they could earn a modest return at a time when profitable lending elsewhere was difficult.

With reserves plentiful, tweaking the supply a bit through open market operations does not affect the federal funds rate, Tkac explains. Think of it this way: even if Bank A needs to borrow from Bank B's reserves, the overall supply is so large that one-off loans here and there will not move the price, or interest rate. It's supply and demand interacting to determine price.

Thus, the traditional open market tool became ineffective. So the Fed shifted to using interest on reserves to influence the fed funds rate.

These interactions can get complicated, and they are hugely important to the nation's economy and financial system. That's why a great deal of research and analysis informs the making of monetary policy. Even after the FOMC decides on the appropriate action, plenty must still happen to make the policy a marketplace reality.

The next installment of this series will explain how the Federal Reserve decides on the appropriate level for the federal funds rate.

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Charles Davidson

Staff writer for Economy Matters