Question

please help me with this

In recent years the Fed’s monetary target has been the federal funds rate. How does the Fed raise or lower that rate, and how is that rate related to other interest rates in the economy such as the prime rate?

Answer 1

The Federal Reserve, through its frequently planned Federal Open Market Committee, increases or lowers interest rates. That's the Federal Reserve Banking System's monetary policy arm.

Following the review of present economic data, the FOMC establishes a target for the fed funds rate. The rate of fed funds is the interest rate charges for overnight loans between banks. These loans are referred to as fed funds. Banks use these resources every night to satisfy the requirement of the federal reserve. If they have insufficient reserves, they will borrow the necessary fed funds.

If the Fed wishes to reduce the level of fed funds, it removes securities from the deposits of the bank and replaces them with credit. It's just like a bank's money. The bank now has more than enough reserves to fulfill its necessity. To lend the additional reserves to other banks, the bank reduces its fed funds rate. To get rid of excess reserves, it will drop the rate as low as needed. It would prefer to lend it a few cents, rather than sitting on its ledger earning nothing.

The Fed does the opposite when it wants to raise rates. It adds securities to the bank's reserves and takes away credit. Now the bank must borrow fed funds to make sure it has enough on hand to meet the reserve requirement that night. If enough banks are borrowing, those that can lend extra fed funds will raise the fed funds rate.

The Fed establishes a cap with its discount rate for the fed funds rate. That's what the Fed borrows from its discount window straight from banks. The Fed sets the rate of discount above the level of fed funds. It would prefer to borrow from one another from banks. The discount rate sets the fed funds rate an upper limit. No bank is able to charge a greater price. If they do, the Fed will just borrow from other banks.

The discount rate and the federal funds rate are both used by banks to maintain reserve requirements. The difference is that banks use the discount rate when borrowing from the Fed, and the federal funds rate when borrowing from other banks.

Since banks have plenty of funds, they don't have much incentive to borrow from each other to meet the reserve requirement. As a result, the Fed will do two other things to raise rates.

First, it will raise the interest rate it pays on required and excess reserves. Banks won't lend money to each other for a lower interest rate than they are already receiving for their reserves. That sets a floor for the fed funds rate.

Second, the Fed is going to increase the inverse repos interest rate. This is a fresh instrument developed by the Fed to regulate the level of fed funds. The Fed "borrows" money overnight from their member banks. It utilizes the Treasuries as collateral that it has on hand. It's not a real loan because it doesn't change hands with money or treasuries. But the Fed is depositing money on the next day in the banks ' accounts. This regulates the level of fed funds as banks will not lend to each other at a reduced rate than they get on the reverse repos