The Fed’s Monetary Policy Tools

The Federal Open Market Committee (FOMC) is schedule to release a new statement on monetary policy this afternoon after their first meetings of the year wrap up. While no major changes are expected, Wall Street is anxiously awaiting what language the FOMC will use to talk about their “exit strategy.” Right now the federal funds rate (commonly talked about as the interest rate) is as low and it can be—0% to .25%—and this has a long-term impact on inflation. At some point the Fed will begin to raise the interest rates, but when is unknown. Raising the federal funds rate would signal begin the process of “exiting” the loose monetary policy the Fed has held since the crisis began.

Some of the tools at the disposal of the Fed for impacting monetary policy right now are:

The Federal Funds Rate: this is the rate that the FOMC sets as a target for banks to use in lending to each other on a daily basis (known as overnight lending). Banks are free to charge whatever rate they want to other banks, and the average rate that is charged from all the deals combined is known as the effective federal funds rate. The Fed then releases more currency into the money supply to try and bring the effective rate in line with their issued targeted rate. The cost of credit and all adjustable rate loans are typically pegged to the FOMC’s federal funds rate (unless they are pegged to another standard like the UK’s Libor). This is the main monetary policy tool the Fed uses.

Purchasing Securities: the Fed has been engaged over the past year in buying mortgage-backed securities from Fannie Mae, Freddie Mac, and Ginnie Mae and shift the risk of the MBSes onto the Fed’s balance sheet. Through the MBS Purchase Program the Fed plans to buy $1.25 trillion in securities and is talking about expanding the program. Buying up the MBSes helps lower borrowing costs, which encourages more currency circulation into the general economy.

Interest Rate on Reserves: if the FOMC wanted to start tightening monetary policy but didn’t want to directly raise the federal funds rate, they could increase the amount the Fed pays banks in interest for keeping money at the Fed in the form of excess reserves. Increasing this payout interest rate would cause lending to be tightened (impacting inflation) and would increase borrowing costs.