The Federal Reserve sets a target for a key short-term interest rate and uses that target to influence the cost of money and credit. Those actions are monetary policy, which the Federal Reserve Board describes as the steps a central bank takes to influence the availability and cost of money and credit in support of national economic goals. The process matters because a change in short-term rates can spread to loans, mortgages, asset prices, and spending across the economy.
What the rate decision is meant to achieve
The Federal Reserve Act mandates that the Federal Reserve conduct monetary policy “so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.” The Federal Reserve Board says this mandate is commonly known as the dual mandate. An economy in which people who want to work have a job or are likely to find one fairly quickly, and in which a broad measure of consumer prices is stable, creates the conditions for interest rates to settle at moderate levels, according to the Board.
Each year, the Federal Open Market Committee explains in a public statement how it interprets those goals and the principles that guide its strategy. The committee judges that low and stable inflation at the rate of 2 percent a year, measured by the annual change in the price index for personal consumption expenditures, is most consistent with both parts of the dual mandate, according to the Federal Reserve Board. It does not set a fixed goal for employment, because the maximum level of employment is largely determined by nonmonetary factors that may change over time and may not be directly measurable.
To assess the employment level that can be sustained, the committee considers a broad range of labor market indicators. Those include how many workers are unemployed, underemployed, or discouraged and have stopped looking for a job, and how hard or easy it is for people to find jobs and for employers to find qualified workers. Policymakers also release estimates of the unemployment rate they expect once the economy has recovered from past shocks and is not hit by new shocks, the Board says.
Who sets the target
Decisions about monetary policy are made at meetings of the Federal Open Market Committee. The Federal Reserve Board says the committee has 12 members: the members of the Board of Governors, the president of the Federal Reserve Bank of New York, and four of the remaining 11 Reserve Bank presidents, who serve one-year terms on a rotating basis. All 12 Reserve Bank presidents attend the meetings and take part in the discussion, but only the presidents who are committee members at the time may vote.
The Federal Reserve Act of 1913 gave the Federal Reserve responsibility for setting monetary policy, according to the Federal Reserve Board. The Board of Governors is responsible for the discount rate and reserve requirements, and the Federal Open Market Committee is responsible for open market operations. The committee holds eight regularly scheduled meetings a year. At those meetings it reviews economic and financial conditions, determines the stance of monetary policy, and assesses risks to its long-run goals of price stability and sustainable economic growth.
The federal funds rate
The committee’s primary means of adjusting the stance of monetary policy is changing its target for the federal funds rate, the Federal Reserve Board says. That rate is the interest rate banks pay to borrow reserve balances overnight. The Board uses the word banks for depository institutions, a class that includes commercial banks, savings banks, savings and loan associations, and credit unions.
Banks hold reserve balances at the Federal Reserve so payments can be settled by transferring those balances, and to meet unexpected liquidity needs and regulatory requirements aimed at keeping banks sound and deposits safe. Banks may borrow and lend reserves depending on their needs and on market conditions. The Board says the committee can influence the federal funds rate by changing the interest rate the Federal Reserve pays on reserve balances held at the Federal Reserve. A bank is unlikely to lend at a rate lower than the rate it can earn on those balances. Changes in the target are typically accompanied by matching changes in the rate paid on reserve balances, which provides an incentive for the federal funds rate to move to a level consistent with the target. Since December 2008, the committee has stated that target as a range that is 25 basis points wide, the Board says.
The Federal Reserve Board also describes three tools of monetary policy: open market operations, the discount rate, and reserve requirements. Using those tools, the Federal Reserve influences the demand for and supply of balances that depository institutions hold at Federal Reserve Banks, and in that way alters the federal funds rate.
How a change spreads through the economy
In the broadest terms, monetary policy works by spurring or restraining growth of overall demand for goods and services, the Federal Reserve Board says. When demand slows relative to the economy’s capacity to produce, unemployment tends to rise and inflation tends to decline. The committee can help stabilize the economy by easing policy, which lowers interest rates and stimulates demand. When demand is too strong, unemployment can fall to unsustainably low levels and inflation can rise. Tightening policy raises interest rates and can guide activity back toward more sustainable levels and keep inflation in check.
Changes in the federal funds rate are rapidly reflected in other short-term rates, including rates that banks and other lenders charge on short-term loans to one another, households, nonfinancial businesses, and government entities. Rates on commercial paper and Treasury bills, which are short-term debt securities issued by private companies and the federal government, typically move closely with the federal funds rate, the Board says. The same is true of many floating-rate loans, including floating-rate mortgages and many personal and commercial credit lines.
Longer-term interest rates are especially important for economic activity and job creation because many large decisions involve long planning horizons, including purchases of houses and cars and business investment in structures, machinery, and equipment. The rates on longer-term loans are related to expectations of how monetary policy and the economy will evolve over the life of the loan, not only to the federal funds rate at the time. Federal Reserve communications about the likely course of short-term rates and the economic outlook, as well as a change in the target, can guide those expectations, the Board says.
Changes in the target can also affect stock prices, household and corporate balance sheets, the terms on which households and businesses borrow, house prices, and the foreign exchange value of the dollar. Over time, those shifts affect spending. When the committee reduces its target, lower rates on consumer loans tend to support spending on durable goods, lower mortgage rates can make buying a house more affordable, and lower financing costs can make some business projects more attractive, according to the Federal Reserve Board. If easing is accompanied by a fall in the exchange value of the dollar, the prices of U.S. products fall relative to foreign products.
When the primary tool is near zero
Nominal interest rates cannot be cut much below zero, if at all, because lenders would find it profitable to convert interest-bearing assets to currency, which has a nominal rate of return of zero, the Federal Reserve Board says. The crisis in financial markets that began in the summer of 2007 led the committee to cut its target from 5-1/4 percent in mid-September 2007 to near zero in late December 2008. With the rate near zero, the Federal Reserve could no longer rely on its primary means of easing policy.
One further form of support, deployed in response to the financial crisis, was explicit forward guidance. The committee conveyed that it likely would keep a highly accommodative stance until a marked improvement in the labor market had been achieved. Short-term interest rates expected in the future, and longer-term bond yields, fell in response, the Board says. Another tool was large-scale asset purchases, which over six years totaled roughly $3.7 trillion in longer-term Treasury securities and securities issued by government-sponsored enterprises. By raising demand for those securities, the Federal Reserve put additional downward pressure on longer-term interest rates and supported easier financial conditions, according to the Board.
In December 2015, the committee raised its target from near zero, a first step toward a more normal stance. In October 2017, it began a gradual reduction in its securities holdings. The committee has indicated that adjustments in the federal funds rate will be the primary way of changing the stance of monetary policy, the Federal Reserve Board says.