Monetary Policy, Interest Rates, and how they affect you

By Roshan Pourghasemi and Jon Scott

In this article we’ll cover…

• Main tools of monetary policy

• How each tool affects the economy

• Loose versus tight monetary policy (economic expansion vs contraction)

• Definition of important terms like “soft landing”, “hawkish”, “dovish”

• Overview of recent monetary policy

In recent months, the Fed has dominated the financial headlines in the news. Due to the rising inflation rates, the Fed has had to raise inflation rates and enact monetary policy. “Rising interest rates” means changing something called the Federal Funds Rate, which in turn changes the interest rate at which banks give loans and has a cascading effect in the economy. When the Fed wants to spur economic growth, they lower interest rates to promote spending, and they do the opposite when they want the economy to move slower, which is a way to counteract inflation.

The Federal Fund Rate and the Three Main Tools of Monetary Policy

Influencing the federal funds rate is the main way that the Fed implements monetary policy and it is usually what people refer to when they say, “the Fed is raising interest rates.” The federal funds rate is the rate that financial institutions charge each other for overnight loans in the market of reserves. It is a target that the Fed aims for through the implementation of monetary policy. Changes in the federal funds rate tend to cause changes in other short-term loan rates, which affect the cost of borrowing for businesses and consumers, and eventually the total amount of money in the economy, employment, and inflation.

The Fed has traditionally used three tools to enact monetary policy: reserve requirements, the discount rate, and open market operations. Typically, it will take one to two years to feel the effects on monetary policy changes. Each of these tools are complex in their own right, but I’ll give a short description of each of them here.

• Reserve requirements are a percentage of a depository institution’s (commercial banks, savings banks, savings and loans, credit unions, and U.S. branches and agencies of foreign banks) deposits that they legally have to put aside and cannot loan out. The Fed has the ability to control this percentage. Typically, these institutions will try to keep their reserves at the bare minimum to meet the reserve requirements in order to loan out the most money possible to customers. By moving reserve requirements, the Fed can influence the amount of money that financial institutions are lending. Stable demand for reserves have reliably allowed the Fed to influence the federal funds rate. Pursuing monetary policy goals through this tool isn’t very common, but they still play an important role in the implementation of monetary policy. Read more about reserve requirements here.

• The discount rate is the interest rate a Reserve Bank charges financial institutions to borrow funds on a short term basis. These transactions are known as borrowing at the “discount window”. The discount rate is set above the federal fund rate target, so it becomes a backup source of funding for financial institutions. By changing the discount rate, the Fed can influence how much money financial institutions borrow, which will in turn affect the money supply. For example, if the Fed raises the discount rate, then it is more expensive for banks to borrow money, so they loan out less and the economy slows down. Read more about discount rates here.

Open market operations are the Fed’s most-used tool for monetary policy. This consists of buying and selling U.S securities on the open market in order to align the federal funds rate with the target set by the Federal Open Market Committee (FOMC). If the Fed wants to raise or lower the federal funds rate, they will sell or buy securities respectively. For example, if the Fed wanted to increase the federal funds rate, they would sell U.S government securities and take money out of the economy’s money supply. By doing this, banks have less money to loan out to business and consumers, and the economy will slow down through interest rates rising across the board. Read more about open market operations here.

Quantitate Easing (QE) - Refers to the Federal Reserve buying assets (typically US treasuries) on the open market in order to push prices on these assets prices up and lower their yield. The Fed’s hope is to spur economic activity by pushing firms and individuals to search for higher returns instead of the low yielding safety of government bonds.

Quantitative Tightening (QT) - Refers to the Fed selling assets or allowing the assets to mature of their balance sheet (instead of repurchasing more assets) in an attempt to push up long-term treasury yields and restrain the Fed’s support of further economic activity.

The Fed publishes a Summary of Economic Projections, which includes a “dot plot” showing the Fed’s projection for what the federal funds rate will be for years to come. However, these projections change as the Fed receives new economic data, so while these projections are the best estimate as of the day the report is released, it is more than likely future economic data will cause a change to the next report’s dot plot.

Key Takeaways

• The federal funds rate is how the Fed implements monetary policy. It is the rate at which financial institutions borrow money from each other.

• The Fed has three main tools to influence the federal funds rate: reserve requirements, discount rates, and open market operations.

• Loose monetary policy is when the Fed is trying to promote economic activity and decreases interest rates; the opposite is called tight monetary policy.

• Loose monetary policy is associated with economic expansion, and tight monetary policy is associated with economic contraction.