An understanding of the history and current makeup of the Federal Reserve helps to understand the tools and powers available to the U.S. central bank, which Fundstrat Head of Research Tom Lee describes as “the most powerful entity in the world.” As discussed in earlier installments, the Fed has a dual mandate: price stability and maximum sustainable employment. 

The Fed seeks to achieve its dual mandate by encouraging the economy to either heat up or cool down. The central bank can help the economy heat up by encouraging businesses and households to borrow, spend, invest, and expand. It can help cool the economy by doing the opposite. 

Open Market Operations

Of course, the Federal Reserve cannot tell businesses and individuals to borrow (or not borrow). Nor can it dictate to banks about the rates at which they should lend money. Instead, the Federal Reserve uses a variety of tools to influence the Federal funds (Fed funds) rate – the interest rate that depository institutions charge to lend each other reserve balances on an overnight basis. This rate, in turn affects all other lending rates charged by banks, and thus all other borrowing in the economy. Lower rates generally lead to higher levels of spending and investment, stimulating the economy and encouraging hiring but potentially also boosting inflation. Higher rates do the opposite, helping to lower inflation by discouraging borrowing and spending. 

The Fed’s primary tool for influencing the federal funds rate is the purchase and selling of US Treasury securities on the open market. Buying securities adds reserves into the banking system, giving banks more money to lend and less need to borrow. Lowering interbank borrowing demand can thus lower the federal funds rate. Conversely, selling securities reduces reserves, making it more likely a bank will need to borrow while decreasing the amount available to be borrowed, thus pushing the rate upwards. In deciding which Treasury securities in which to transact, the Fed typically considers maturity, duration, and liquidity. 

Discount rate

On a related note, the Fed also lends money to banks and other depository institutions on an overnight basis. The interest the Fed charges to banks for such short-term loans is known as the discount rate. While this lending facility is primarily used to help maintain banking system stability and help banks from failing, the discount rate can be used to set a ceiling for the Fed funds rate – if the discount rate is lower than the Fed funds rate, banks would obviously prefer to borrow from the Fed rather than other banks. 

IORB

Similarly, the Fed can set a floor on the Fed funds rate by changing the interest rate that it pays on reserve balances that banks keep at the Federal Reserve itself.  If this rate, the IORB (interest on reserve balances), is ever above the Fed funds rate, banks would be incentivized to keep more of their reserves on deposit at the Fed, as this would earn more interest than lending to other banks. Eventually, this diminished willingness to lend to other banks causes the Fed funds rate to rise. (Conversely, if the Fed decides to set the IORB rate lower than the Fed funds rate, this increases banks’ willingness to lend their reserves to other banks, and this exerts downward pressure on the federal funds rate.)

Reserve requirements 

Finally, the Fed can also use its power as a banking system regulator to influence lending. The Fed has the authority to set reserve requirements – the minimum portion of deposits banks must hold as reserves. The lower the reserve requirement, the more money banks have to lend. This generally causes lending rates to fall and encourages borrowing. Conversely, increasing reserve requirements means less money available for banks to lend out, making it more expensive to borrow. The use of reserve requirements to restrict lending is generally seen as less preferable because it can incentivize banks to become overleveraged and thus can impact the safety and soundness of the banking system. Furthermore, there tends to be more of a lag between a change in reserve requirements and its effect  on borrowing. 

One Final Tool

In the early history of the Federal Reserve, the central bank did not make a habit of making public announcements about its policy decisions or its work. It did not, for instance, publicly disclose changes to its target for the Fed funds rate. 

This began to change after the Great Inflation of the 1970s, when Fed officials perceived that their failure to confront rising inflation had not only hurt the bank’s credibility with the public, but also helped to entrench or anchor expectations for high inflation. To combat this, the Fed began to engage the press more actively.

Over the years, this has led to increasingly greater transparency by the Fed, and officials have come to realize that effectively communicating policy, views, expectations, and details about the decision-making process could not just garner credibility, but also influence economic behavior.

To that end, FOMC members engage the press and communicate with the public at various conferences and events. As a result, it is rare for the market participants to be surprised by the FOMC.  When Lee, Newton, or Farrell talk about “Fed Day,” they are referring to the communications released after the regular meetings of the FOMC, which include not just an announcement about the Fed’s target range for the Fed funds rate, but also a press statement, an accompanying report that summarizes the expectations of each FOMC for future inflation, Fed funds targets, economic growth, and employment, and a press conference by the Federal Reserve Chair that includes a question-and-answer session. All of these are important tools that the Fed uses to influence economic decisions by businesses and households.