Monetary Policy, Part 2: Two Important Interest Rates in Monetary Policy Implementation

When the Federal Open Market Committee, the FOMC, conducts monetary policy, it is taking actions to manage financial conditions that encourage the economy to move towards the Fed’s goals of maximum employment and price stability. It does so by setting a target range for the federal funds rate. 

But wait, what is the federal funds rate? It is easiest to think about it as a short-term interest rate that banks charge when they lend funds to another bank. 

Let’s make sure we get what this important interest rate is. Banks hold funds in accounts at the Fed called reserve balance accounts. When Bank A needs to borrow funds, it might borrow them from Bank B if Bank B has extra reserve balances. When banks borrow from each other like this, it’s typically just overnight. The next day, Bank A returns the funds plus a bit of interest to Bank B. These transactions occur in the federal funds market, and the interest rate banks agree to is the federal funds rate. 

On any given day, there are many transactions in the federal funds market, and they settle at slightly different federal funds rates.  The effective federal funds rate, measures the median rate of all these transactions. The FOMC sets the target range for where it wants this effective federal funds rate to be or, in other words, a majority of the transactions should fall within the target range. So how does the Fed make sure this happens? It uses one of the interest rates that it sets called “interest on reserve balances.” As the name implies, the Federal Reserve pays interest on the reserve balances banks hold in their accounts at their regional Federal Reserve Bank. 

For banks, their reserve balance account offers a safe, risk-free, overnight investment option. If they have excess funds, they can always deposit them into their reserve balance account and earn interest, just like you can do with a savings account. 

But the interest rate on reserve balances is more than an opportunity for banks to earn interest. This rate is an important tool that the Fed uses to steer the federal funds rate into the FOMC’s target range. And two economic concepts help explain how this process works: reservation rate and arbitrage. Join us in Part 3 to find out what those concepts mean and how they work. "