Tools of Monetary Policy
The Federal Reserve aims to influence the economy, inflation and employment levels through its monetary policy. One of the tools it uses to conduct monetary policy is setting a target for the federal funds rate.
This is the short-term interest rate at which U.S financial
institutions (such as banks, credit unions, and others in the Federal
Reserve system) lend money to each other overnight in order to meet
mandated reserve levels. Each borrowing and lending bank negotiates the
interest rate individually. Together, the average of all these rates
make up the federal funds rate.
As with mortgage rates, the Federal Reserve does not directly set the
federal funds rate. Instead, it sets a target for the federal funds
rate and engages in actions to influence the rate towards the target.
The federal fund rate affects all other rates including short- and
long-term interest rates, forex
and a host of other downstream effects. In recent years, the Fed has
maintained its target federal funds rate at the lowest it can go—from .25 percent to .5 percent.
A major way the Fed can influence the federal funds rate is by wielding another one of its monetary policy tools—open market operations. This is when the Fed buys and sells government securities such as bonds.
When the central bank wants to tighten monetary policy and targets a
higher federal funds rate, it absorbs money from the system by selling
off government bonds.
And when it wants an easier monetary policy and targets a lower
federal funds rate, the Fed engages in the opposite course of action of
buying government securities so as to introduce more money into the
system. Where does the money to buy all these government bonds come
from? As the central bank, the Fed can simply create the money.
In addition to targeting the federal funds rate and using open market
operations, the Fed also has other tools to influence monetary policy.
These include changing bank reserve requirements by making them higher
or lower, changing the terms on which it lends to banks through its
discount window, and changing the rate of interest it pays on the bank
reserves it has on deposit.
When the Federal Reserve makes it more expensive for banks to borrow
by targeting a higher federal funds rate, the banks in turn pass on the
higher costs to its customers. Interest rates on consumer borrowing,
including mortgage rates, tend to go up. And as short-term interest
rates go up, long-term interest rates typically also rise. As this
happens, and the interest rate on the 10-year Treasury bond which influences the rate on the conventional 30-year mortgage moves up, mortgage rates also tend to rise. (Related The Tangled Web of Interest Rates, Mortgage Rates, And The Economy)
Mortgage lenders set interest rates based on their expectations for
future inflation and interest rates. The supply of and demand for
mortgage-backed securities also influences the rates. Thus, the Federal
Reserve’s actions have a ripple effect in terms of impacting mortgage
The Bottom Line
The Federal Reserve’s aims to maintain economic stability and impacts bank lending rates.
When the Fed wants to boost the economy, it typically becomes less
expensive to take out a mortgage. And when the Fed wants to clamp down
on the economy, it acts to drain money from the system, which means
borrowers will likely pay a higher interest rate on mortgages.To know more visit our site http://allindiayellowpage.com