What is
monetary policy?
The term
"monetary policy" refers to the actions undertaken by a central
bank, such as the Federal Reserve, to influence the availability and cost
of money and credit to help promote national economic goals. The Federal
Reserve Act of 1913 gave the Federal Reserve responsibility for setting
monetary policy.
The Federal
Reserve controls the three tools of monetary policy--open market
operations, the discount rate, and reserve requirements. The Board of
Governors of the Federal Reserve System is responsible for the discount
rate and reserve requirements, and the Federal Open Market Committee is
responsible for open market operations. Using the three tools, the Federal
Reserve influences the demand for, and supply of, balances that depository
institutions hold at Federal Reserve Banks and in this way alters the
federal funds rate. The federal funds rate is the interest rate at which
depository institutions lend balances at the Federal Reserve to other
depository institutions overnight.
Changes in the
federal funds rate trigger a chain of events that affect other short-term
interest rates, foreign exchange rates, long-term interest rates, the
amount of money and credit, and, ultimately, a range of economic variables,
including employment, output, and prices of goods and services.
Open market
operations
purchases and
sales of U.S. Treasury and federal agency securities--are the Federal
Reserve's principal tool for implementing monetary policy. The short-term
objective for open market operations is specified by the Federal Open
Market Committee (FOMC). This objective can be a desired quantity of
reserves or a desired price (the federal funds rate). The federal funds
rate is the interest rate at which depository institutions lend balances at
the Federal Reserve to other depository institutions overnight.
The Federal Reserve's objective for open market operations has varied over
the years. During the 1980s, the focus gradually shifted toward attaining a
specified level of the federal funds rate, a process that was largely
complete by the end of the decade. Beginning in 1994, the FOMC began
announcing changes in its policy stance, and in 1995 it began to explicitly
state its target level for the federal funds rate. Since February 2000, the
statement issued by the FOMC shortly after each of its meetings usually has
included the Committee's assessment of the risks to the attainment of its
long-run goals of price stability and sustainable economic growth.
Discount Rate
is the interest
rate charged to commercial banks and other depository institutions on loans
they receive from their regional Federal Reserve Bank's lending
facility--the discount window. The Federal Reserve Banks offer three
discount window programs to depository institutions: primary credit,
secondary credit, and seasonal credit, each with its own interest rate. All
discount window loans are fully secured.
Under the primary credit program, loans are extended for a very short term
(usually overnight) to depository institutions in generally sound financial
condition. Depository institutions that are not eligible for primary credit
may apply for secondary credit to meet short-term liquidity needs or to
resolve severe financial difficulties. Seasonal credit is extended to
relatively small depository institutions that have recurring intra-year
fluctuations in funding needs, such as banks in agricultural or seasonal
resort communities.
The discount rate charged for primary credit (the primary credit rate) is
set above the usual level of short-term market interest rates. (Because
primary credit is the Federal Reserve's main discount window program, the
Federal Reserve at times uses the term "discount rate" to mean
the primary credit rate.) The discount rate on secondary credit is above
the rate on primary credit. The discount rate for seasonal credit is an
average of selected market rates. Discount rates are established by each
Reserve Bank's board of directors, subject to the review and determination
of the Board of Governors of the Federal Reserve System. The discount rates
for the three lending programs are the same across all Reserve Banks except
on days around a change in the rate.
Reserve
requirements
are the amount of
funds that a depository institution must hold in reserve against specified
deposit liabilities. Within limits specified by law, the Board of Governors
has sole authority over changes in reserve requirements. Depository
institutions must hold reserves in the form of vault cash or deposits with
Federal Reserve Banks.
The dollar amount of a depository institution's reserve requirement is
determined by applying the reserve ratios specified in the Federal Reserve
Board's Regulation D to an institution's reservable liabilities (see table
of reserve requirements). Reservable liabilities consist of net transaction
accounts, nonpersonal time deposits, and eurocurrency liabilities. Since
December 27, 1990, nonpersonal time deposits and eurocurrency liabilities
have had a reserve ratio of zero.
The reserve ratio on net transactions accounts depends on the amount of net
transactions accounts at the depository institution. The Garn-St Germain
Act of 1982 exempted the first $2 million of reservable liabilities from
reserve requirements. This "exemption amount" is adjusted each
year according to a formula specified by the act. The amount of net
transaction accounts subject to a reserve requirement ratio of 3 percent
was set under the Monetary Control Act of 1980 at $25 million. This
"low-reserve tranche" is also adjusted each year (see table of
low-reserve tranche amounts and exemption amounts since 1982). Net
transaction accounts in excess of the low-reserve tranche are currently
reservable at 10 percent.
Beginning October 2008, the Federal Reserve Banks will pay interest on
required reserve balances and excess balances.
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