fed funds target rate

Examples of fed funds target rate in the following topics:

• The Discount Rate

  • The interest rate is an active target and is set as a target rate range by the Fed; it is conveyed to the public by the Federal Reserve Open Market Committee (FOMC) as the fed funds target rate (short for the Federal Funds rate).
  • The Fed targets the rate for federal funds via its open market operations and seeks to be the lender of last resort by charging banks a higher rate than the federal funds rate .
  • Typically, the discount rate along with the fed funds target rate are mechanisms that the Fed uses to discourage banks from excess lending, as part of a contractionary or restrictive policy scheme.
  • In this manner, the discount rate in tandem with the fed funds target rate are part of an expansionary policy mechanism.
  • The discount rate is higher than the fed funds target rate and the variance serves as a disincentive for banks to seek funds or short-term borrowings from the Fed.

• Open Market Operations

  • These include the discount rate, the fed funds target rate, and the reserve requirement, and open market operations (OMOs).
  • Historically, the Federal Reserve has used OMOs to adjust the supply of reserve balances so as to keep the federal funds rate--the interest rate at which depository institutions lend reserve balances to other depository institutions overnight--around the target established by the FOMC.
  • The interest rate targeted through the OMO manipulation of the money supply is the fed funds target rate or the rate that member Fed banks charge one another for overnight loans.
  • The target rate is important monetary tool from the perspective that the higher the fed funds rate relative to the return on loanable funds, the greater the incentive for banks to meet their reserve requirement (the bank will lose money) thereby placing limits on the growth of the money supply through the loanable funds market.
  • In addition to this direct interest rate channel, the fed funds rate influences many other interest rates in the economy and by so doing contributed to either incentivizing borrowing for growth or disincentivizing the same.

• Setting and Achieving the Interest Rate Target

  • The rate that Fed member banks charge one another is referred to as the Federal Funds rate, or Fed Funds rate for short (rate for funds held at the Fed).
  • The rate is indirectly influenced and targeted by the Fed via a direct channel of open market operations and is communicated to the public as a Fed Funds target range as a standard part of the Fed Open Market Committee communications.
  • It is important to note that the Fed does not set the fed funds target rate, it only issues a range that it targets through active management of the money supply.
  • The fed funds rate will be within the range of the target; if not the Fed will adjust its open market operations (buying and selling of bonds) to achieve the range .
  • The graphic depicts the movement in the effective federal funds target rate.

• Executing Expansionary Monetary Policy

  • The interest rate on the overnight borrowing of reserves is called the Federal Funds rate or simply the "fed funds rate."
  • For example, if the supply of reserves in the fed funds market is greater than the demand, then the funds rate falls, and if the supply of reserves is less than the demand, the funds rate rises.
  • At a lower fed funds rate, banks are more likely to increase loans, thereby expanding investment activity (in factories, for example, not financial instruments) and promoting economic growth.
  • Expansionary monetary policy will seek to reduce the fed funds target rate (a range).
  • Thus, the Fed's open market purchase increased the supply of reserves (money) to the banking system, and the federal funds rate (interest rate) falls.

• The Federal Open Market Committee and the Role of the Fed

  • When conducting monetary policy the Fed sets a target for the federal funds rate, which it attempts to achieve using open market operations.
  • To lower the federal funds rate, for example, the Fed buys securities on the open market, increasing the money supply.
  • In order to raise the federal funds rate, on the other hand, the Fed sells securities and thereby reduces the money supply.
  • Monetary targets, such as inflation, interest rates, or exchange rates, are used to guide this implementation.
  • Imagine the Fed is targeting a federal funds rate of 3%.

• Time Lags and Targets

  • The Fed uses its tools to influence the intermediate targets, and the intermediate targets directly affect the price level, unemployment rate, and economic growth rate.
  • Operating targets are the federal funds rate and non-borrowed reserves.
  • Federal funds rate is the interest rate that banks charge for lending their excess reserves to other banks.
  • When the Fed uses open-market operations, changes discount policy, or alters reserve requirement, the Fed's monetary policy has an immediate impact on the federal funds rate and non-borrowed reserves.
  • For example, the Fed selected interest rates as its intermediate target.

• The Federal Funds Rate

  • The Federal Funds rate (or fed funds rate) is the interest rate at which depository institutions (primarily banks) actively trade balances held at the Federal Reserve.
  • A high Federal Funds rate, therefore, has a contractionary effect on economic activity, while a low Federal Funds rate has an expansionary effect.
  • The Fed doesn't control the Federal Funds rate directly - it is negotiated between borrowing and lending banks - but it does set a target interest rate and uses open market operations in order to achieve that rate.
  • The target Federal Funds rate is decided by the governors at the Federal Open Market Committee (FOMC) meetings, who will either increase, decrease, or leave the target rate unchanged based on the economic conditions within the country .
  • Influencing the Federal Funds rate is the primary monetary policy tool that the Fed uses to achieve its dual mandate of stable prices and low unemployment.

• Chapter Questions

  • What happens to bank reserves, interest rates, bond prices, and the money supply if the Fed bought U.S.
  • What happens to bank reserves, interest rates, bond prices, and the money supply if the Fed sold U.S.
  • Explain why the Fed concentrates on the growth rate of the money supply or short-term interest rates, but not both at the same time.
  • What happens to the short-term interest rates, bank reserves, and the money supply if the Fed changes the discount rate?
  • Why do the financial analysts and the public scrutinize the federal funds market?

• Answers to Chapter 14 Questions

  • If the Fed concentrated on the interest rate, it must buy or sell bonds to achieve the target interest rate.
  • When the Fed conducts monetary policy, the policy affects the federal funds rate first.
  • If the federal funds rate rises, then the Fed may be pursuing contractionary monetary policy.
  • If the federal funds rate drops, subsequently, the Fed may be using expansionary monetary policy.
  • Monetary policy has an immediate impact on operating targets like the federal funds rates and non-borrowed reserves.

• Discount Policy

  • For example, a bank could borrow funds from the Fed at 2% and lend these funds out at 5%, earning 3% interest on the Fed loans.
  • For example, when the public and financial analysts see the federal funds interest rate fall, they infer the Fed is using expansionary policy.
  • On the other hand, if the federal funds rate rises, the public believes the Fed is using contractionary monetary policy.
  • As you know from this chapter, the Fed cannot control the federal funds rate, but can only influence it.
  • Other factors can cause the Federal Funds rate to rise or fall.