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Interbank lending is the basis of policy

30 April, 2015 - 17:57

The Federal Reserve sets monetary policy by influencing the Federal funds rate, which is the rate of interbank lending of excess reserves. The rate that banks charge each other for these loans is determined in the interbank market but the Federal Reserve influences this rate through the three "tools" of monetary policy described in the Tools section below.

The Federal Funds rate is a short-term interest rate the FOMC focuses on directly. This rate ultimately affects the longer-term interest rates throughout the economy. A summary of the basis and implementation of monetary policy is stated by the Federal Reserve:

The Federal Reserve implements U.S. monetary policy by affecting conditions in the market for balances that depository institutions hold at the Federal Reserve Banks...By conducting open market operations, imposing reserve requirements, permitting depository institutions to hold contractual clearing balances, and extending credit through its discount window facility, the Federal Reserve exercises considerable control over the demand for and supply of Federal Reserve balances and the federal funds rate. Through its control of the federal funds rate, the Federal Reserve is able to foster financial and monetary conditions consistent with its monetary policy objectives 1.

This influences the economy through its effect on the quantity of reserves that banks use to make loans. Policy actions that add reserves to the banking system encourage lending at lower interest rates thus stimulating growth in money, credit, and the economy. Policy actions that absorb reserves work in the opposite direction. The Fed's task is to supply enough reserves to support an adequate amount of money and credit, avoiding the excesses that result in inflation and the shortages that stifle economic growth 2.