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 five of
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. All 12 presidents participate fully in FOMC
discussions. Reserve Bank boards of directors, research departments and
regional business leaders contribute grassroots information and insights
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 primary
monetary policy tool is open market operations, which is 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 to stimulate the
economy, or 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 (officially the primary credit rate) is
the interest rate the Federal Reserve Banks charge financial
institutions for short-term loans of reserves. The volume of reserve
balances supplied is usually only a small portion of the total supply of
Federal Reserve balances. However, at times of market disruption, such
as the September 11, 2001, terrorist attacks, loans extended through the
discount window can supply a considerable volume of Federal Reserve
balances.
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 rarely changes the reserve requirement. 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.