Federal Monetary Policy: How and Why It's Central to Our Economy

Chief Executive (U.S.), April 2005 | Go to article overview

Federal Monetary Policy: How and Why It's Central to Our Economy


In 1913, in response to a series of bank failures, Congress passed the Federal Reserve Act and established the central banking system we have today. The Federal Reserve Board has multiple responsibilities, but most people know this small group of esteemed bankers and economists for setting target interest rates.

What happens when the Federal Reserve Board proclaims its target interest rate after each of the eight times it meets annually? Most people are surprised to hear that the nicely rounded quarter percent figure is just an aspiration. The Intended Federal Funds Rate that the Reserve Board sets is not the rate at which people can borrow money; it is just a projection.

What the Federal Reserve Board actually does is announce an interest rate it hopes to achieve through policy, then buys or sells Treasury bills accordingly. This purchase or sale of government securities accumulates in a central bank account at each regional Federal Reserve Bank, from which its member banks can lend money. Because the Board also sets the required percentage of money that banks must have on hand for each dollar lent, the amount of reserves the Fed decides to buy or sell after each meeting directly affects the amount of money banks have to lend. Thus, when the Fed injects more reserves into the system, banks have more money, and they lower interest rates to reach a market equilibrium between those who lend money and those who need to borrow money. Since those who have a need for loans are quite often entrepreneurs and companies, actions by the Fed impact the rate at which money is invested in our economy.

The rate that the Fed arrives at after each meeting (currently 2.75%) is determined by a series of intense calculations regarding the current strength of our economy and its expected strength in the future (long and short term). As a result, these projections are ballpark figures and the net impact of the Fed's actions is either one of two things: a measure to slow the economy or a measure to speed it up. Because the Feel's job does not require pinpoint precision, forecasts can be used to affect our economy in the years to come (for a discussion of the consequences of this, see page 5). Interest rates were high throughout the mid 1990's dropping below 5% only once since the beginning of 1995 and, reached their highest point in early 2000, right when the Internet bubble burst (see chart below).

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Federal Monetary Policy: How and Why It's Central to Our Economy
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