How does the U.S. Federal Reserve change the federal funds rate?

Explanation of rate changes.

The federal funds rate is the rate at which banks charge each other for inter-day or over-night loans. The federal reserve has no direct control over this rate. The term "federal funds" comes from the fact that banks are required to deposit reserves with the Fed, and either borrow or lend (buy or sell) reserves as they are needed at the Fed.

Banks find it necessary at times to buy funds to meet reserve requirements that are set by the Fed and obligated by law. When banks borrow to meet reserve requirements they do so in the federal funds market. Likewise, a bank with excess reserves may also use the federal funds market, this time in the role of lender. The Fed acts as an unbiased intermediary transferring debt and giving credit to individual bank reserves. In the federal funds market, the cost of borrowing and return to lending is the federal funds rate. Although the Fed has no direct control over the federal funds rate, it can influence it, forcing it to stay within a narrow band. In its monthly Federal Open Market Committee (FOMC) meetings, the Fed's governors choose a federal funds target, which banks use as they determine the funds rate. Maintenance of the federal funds rate occurs in open market operations.

In an open market operation, the Fed can either sell or purchase financial assets. If the Fed sells assets, that is, government bonds and notes, it is adopting a tight monetary policy, as money is taken out of the economy, or more specifically out of bank reserves. And the fed funds rate rises as demand for reserves remain constant or even rise and actual reserve supplies decline. The other option the Fed has is to repurchase outstanding securities and government debt, and credit the bank's reserve. In this case the Fed funds rate would decline as demands remain constant or rise, but supply of reserves rises enough to offset the demand.

In lieu of the federal funds market, a bank can also use the discount window, that is, borrow directly from the Fed to maintain its reserve requirement. The interest charged by the Fed is termed the discount rate. In most cases the discount rate is lower than the federal funds rate. You may wonder why banks just don't borrow from the discount window, since it is lower than the funds rate. The reason is that the discount window is the market of last resort for loans. That is, the Fed is to be used only in unusual circumstances. When banks borrow from the Fed, the Fed demands time consuming procedures and documents. In many cases, the dollar value of preparing these requirements will often offset the savings in interest payments from borrowing from the Fed. Aside from the value of preparation time there is also an image issue. Banks, not to mention the Fed, frown upon habitual borrowing at the discount window, and those banks that do so on a regular basis (unless there are extenuating circumstances) are likely to be in dire financial straits. That impression would not likely gain or maintain clients.

Why do banks sometimes fail to meet their reserve requirements? Banks*, like other companies, try to make a profit. After all, they have to pay for buildings and staff and various other costs, not the least of which is interest paid to depositors. In order to generate revenue, banks make investments and loans for which they charge a higher rate of interest then they pay on deposits. Banks are able to charge higher interest for borrowing for a variety of reasons, chief amongst these is risk. That is, people default on loans, businesses go bad, and bankruptcies are declared-the end result being that any monies lent or invested in these ventures are lost. Banks are compensated for assuming this added risk through higher interest rates. In most circumstances, banks attempt to lend every dollar of deposits they possibly can. Unborrowed reserves lose value because of the inflation tax; rising prices erode the real value of money over time. Moreover, banks have to pay interest on their deposits. Thus, having money in reserves is a double whammy for banks it essentially costs them interest payments plus inflation, while at the same time generating no revenue.

Because reserve requirements are not reconciled every moment, banks can and do fall below reserve requirements at various times during the day. Actually the reconciliation of reserve to deposit ratios uses a formula involving the calculations of the average reserves over a two-week period. Thus technically banks can fall below at any day, but if they do they must have excess on another day to compensate, so it is in the best interest of banks to reconcile at the end of each day.

Why would the Fed want to control the federal funds rate? Every interest rate denominated in U.S. dollars is influenced by every other interest rate denominated in U.S. dollars. Any time it is not, arbitrage quickly corrects the situation. And in many cases the federal funds rate is the basis by which other rates are calculated. Thus by controlling the federal funds rate the Fed can exert a tremendous influence over financial and goods markets in the U.S. and abroad.

How easy is it for the fed to contain the federal funds rate within a narrow band of its target? It isn't easy at all. The fed must diligently keep watch of the economy on a daily basis. It must back its decision to buy or sell government securities based on macro level indicators. As mentioned above it can not control the funds rate directly. The interaction between the supply of and demand for money determines the federal funds rate. While the Fed can, to a certain extent, control the supply of money, it cannot control money demand. To control the stock of money, the Fed engages in open market operations. By buying and selling government securities it can influence the supply of money, which in turn effects interest rates.

Controlling the money stock has many difficulties and implications; one of the most important is the multiplier effect. The multiplier effect is the idea that a $1.00 injection of new money actually increases the money supply by an amount greater than $1.00. To understand this, recall that when banks take in deposits, they keep only a portion of that deposit and lend the rest. Since all or most of a bank's loans ultimately end up as bank deposits, and are thus lent again, the money supply is increased by more than the original injection. For example, if the Fed, through open market operations were to create, say, $100 of new money and if the reserve requirement were, say, 10%, banks would initially make $90 in new loans. This $90 is soon redeposited in banks, who then make an additional $81 in loans, and so on. As one can see, this $100 of new money increased the money supply by more than $100 after only two rounds of a theoretically infinite process. A variety of factors make it difficult to accurately estimate this multiplier effect. It is not necessarily the case that every dollar of bank loans ends up being deposited. For example, individuals and firms may (for whatever reason) choose to hold cash instead of using a bank. Likewise, this money may be taken out of the U.S. Moreover, it may be that banks do not make the maximum amount of loans for a given volume of deposits.

Another factor that has made the Fed's job more difficult is the increasing complexity of the financial system. The past 25 years have seen an explosion in the number and complexity of investment vehicles available to individuals, firms, and banks. Take for example credit cards, the use of which has become ubiquitous in recent years. As our financial system becomes more and more complicated, it has become more and more difficult to quantify and predict the effects of policy, making monetary policy a dicier game than in years past.

In the end the driving principle behind Fed policy is simple and basic. That principle is one of supply and demand- a principle applied everywhere, from the lemonade stand to workings of industrial economies. Yet successfully implementing that principle, basic as it may be, can be a difficult and contentious undertaking.

Please read our analysis of the latest FOMC Meeting.