How the Federal Reserve Devises Monetary Policy

A monetary policy is the means by which a central bank (also known as the "bank's bank" or the "bank of last resort") influences the demand, supply and, therefore, price of money and credit, in order to direct a nation's economic objectives. Following the Federal Reserve Act of 1913, the Federal Reserve (the U.S. central bank) was given the authority to formulate U.S. monetary policy. To do this, the Federal Reserve uses three tools: open market operations, the discount rate and reserve requirements.

Within the Federal Reserve, the Federal Open Market Committee (FOMC) is responsible for implementing open market operations, while the Board of Governors looks after the discount rate and reserve requirements.

The three instruments we mentioned above are used together to determine the demand and supply of the money balances that depository institutions, such as commercial banks, hold at Federal Reserve banks. The dollar amount placed with the Federal Reserve in turn changes the federal funds rate. This is the interest rate at which banks and other depository institutions lend their Federal Bank deposits to other depository institutions — banks will often borrow money from each other to cover their customers' demands from one day to the next. So, the federal fund rate is essentially the interest rate that one bank charges another for borrowing money overnight. The money loaned out has been deposited into the Federal Reserve based on the country's monetary policy.

The federal funds rate is what establishes other short-term and long-term interest rates and foreign currency exchange rates. It also influences other economic phenomena, such as inflation. To determine any adjustments that may be made to monetary policy and the federal funds rate, the FOMC meets eight times a year to review the nation's economic situation in relation to economic goals and the global financial situation.

(To learn about the relationship between inflation and bonds read Understanding Interest Rates, Inflation and the Bond Market.)

Open market operations are essentially the buying and selling of government-issued securities (such as U.S. T-bills) by the Federal Reserve. It is the primary method by which monetary policy is formulated. The short-term purpose of these operations is to obtain a preferred amount of reserves held by the central bank and/or to alter the price of money through the federal funds rate.

When the Federal Reserve decides to buy T-bills from the market, its aim is to increase liquidity in the market, or the supply of money, which decreases the cost of borrowing, or the interest rate.

On the other hand, a decision to sell T-bills to the market is a signal that the interest rate will be increased. This is because the action will take money out of the market (too much liquidity can result in inflation), therefore increasing the demand for money and its cost of borrowing.

(To learn more read How the Federal Reserve Manages Money Supply.)

The discount rate is essentially the interest rate that banks and other depository institutions are charged to borrow from the Federal Reserve. Under the federal program, qualified depository institutions can receive credit under three different facilities: primary credit, secondary credit and seasonal credit.

Each form of credit has its own interest rate, but the primary rate is generally referred to as the discount rate.

• The primary rate is used for short-term loans, which are basically extended overnight to banking and depository facilities with a solid financial reputation. This rate is usually put above the short-term market-rate levels.
• The secondary credit rate is slightly higher than the primary rate and is extended to facilities that have liquidity problems or severe financial crises.
• Finally, seasonal credit is for institutions that need extra support on a seasonal basis, such as a farmer's bank. Seasonal credit rates are established from an average of chosen market rates.

(For more read Internal Rate of Return: An Inside Look.)

The reserve requirement is the amount of money that a depository institution is obligated to keep in Federal Reserve vaults, in order to cover its liabilities against customer deposits. The Board of Governors decides the ratio of reserves that must be held against liabilities that fall under reserve regulations. Thus, the actual dollar amount of reserves held in the vault depends on the amount of the depository institution's liabilities.

Liabilities that must have reserves against them include net transactions accounts, non-personal time deposits and euro-currency liabilities; however, since Dec. 1990, the latter two have had reserve ratio requirements of zero (meaning no reserves have to be held for these types of accounts).

By influencing the supply, demand and cost of money, the central bank's monetary policy affects the state of a country's economic affairs. By using any of its three methods — open market operations, discount rate or reserve requirements — the Federal Reserve becomes directly responsible for prevailing interest rates and other related economic situations that affect almost every financial aspect of our daily lives.

(For more on the Fed, read The Fed's Tools for Influencing the Economy.)