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Consumer Guide To Interest Rates

The Fed's Role

  • What is monetary policy?
  • How does the Fed formulate monetary policy?
  • How does the Fed implement monetary policy?
  • What is the discount rate?

What is Monetary Policy?

Monetary policy consists of the efforts of the Federal Reserve ("the Fed," for short), the central bank of the United States, to influence money and credit conditions in the economy in order to achieve the country’s macroeconomic goals.

Those goals include stable prices, high employment, and maximum sustainable growth in the economy. Prices are considered stable when they change slowly enough so that people pay little attention to price changes in making economic decisions.

Growth can be measured by the rate of change of real gross domestic product (GDP) — that is, the output of the economy adjusted for changes in prices. The level of sustainable growth, the rate at which the economy can grow without causing the inflation rate to accelerate, is determined by how fast the hours worked by the U.S. labor force and output per worker grow.

How Does the Fed Formulate Monetary Policy?

The Fed formulates monetary policy by setting a target for the federal funds rate, the interest rate that banks charge one another for very short-term loans.

Because the fed funds rate is what banks pay when they borrow, it affects the rates they charge when they lend. Those rates, in turn, influence other short-term interest rates in the economy, and, with a lag, economic activity and the rate of inflation.

How Does the Fed Implement Monetary Policy?

The Fed uses open market operations, the sale or purchase of previously issued U.S. government securities, to influence the amounts that banks can lend, thereby raising or lowering the federal funds rate. When the Fed buys securities, it injects funds into the banking system, giving banks more to lend and putting downward pressure on the fed funds rate; when it sells securities, it does the opposite.

The results of the Fed’s monetary policy actions cannot be predicted with precision. The Federal Reserve’s influence over short-term interest rates can create conditions conducive to economic growth, but ever-changing market and political conditions, here and abroad, also heavily influence the millions of economic and financial decisions of households and businesses.

What is the Discount Rate?

The Federal Reserve sets the discount rate, which is the interest rate that banks pay on short-term loans from the Fed. The Fed often makes identical changes in its target for the federal funds rate and in the discount rate. Thus, discount rate cuts typically reflect the Fed’s desire to stimulate the economy, and increases in the discount rate often reflect the Fed’s concern over the threat of inflation.

For monetary policy purposes, the discount rate is not as important as the federal funds rate, because banks don’t borrow very much from the Fed.

The Federal Reserve stresses that it is a "lender of last resort." That means the banks have to try to borrow elsewhere before they come to borrow from the Fed, and it means also that a bank should not ask to borrow from the Fed too often.

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