How the Fed Sets Monetary Policy

• 1). Assess current economic conditions at regular monetary policy meetings. The Fed's policy making body, known as the Federal Open Market Committee (F.O.M.C.), meets eight times a year in Washington, D.C., to make monetary policy decisions. The committee consists of the Fed's board of governors and the presidents of the Federal Reserve Bank of New York and four other Federal Reserve banks, chosen in rotation. At the meetings, committee members review the most recent economic data. When assessing the economy's overall health, policy makers must consider that their decisions take time to affect the economy.
  
  
• 2). Set the federal funds rate at the desired level. The federal funds rate is the interest rate that banks charge each other for overnight loans. The Federal Reserve's website reports that after reviewing the most recent economic indicators, the F.O.M.C. sets a target for the federal funds rate. If the data suggest a rise in inflation, the Fed may boost the federal funds rate to keep the economy from growing too rapidly, fueling further inflation. Signs of a sluggish economy may result in a decision to lower the federal funds rate. In some cases, the F.O.M.C. will leave the rate unchanged. After choosing a desired target, the Fed then uses the three main tools of monetary policy to achieve that targeted rate: open market operations, discount lending and banking reserve requirements.
  
  
• 3). Conduct open market operations, which involve the sale or purchase of government securities on the open market. The Federal Reserve Bank of New York conducts open market operations, buying or selling securities based on the targeted federal funds rate. If the Fed wants the rate to decrease, it buys securities from a bank and pays for them by increasing the bank's reserves, i.e. the balance of cash the bank has on deposit with the Fed. According to the Federal Reserve Bank of San Francisco, U.S. banks hold reserves as cash in vaults and as deposits with the Fed. When the Fed increases a bank's reserves, the bank has additional reserves for lending to other banks in the federal funds market. If the Fed wants to raise the targeted federal funds rate, it does the opposite and sells securities to banks.
  
  
• 4). Adjust the discount rate and banking reserve requirements. The discount rate is the interest rate the Fed charges banks for direct loans of reserve funds. The discount rate is typically higher than the federal funds rate because the Fed wants banks to use the federal funds market as a first resort for overnight loans of reserves. Reserve requirements refer to the amount of money banks must hold in their vaults or on deposit with the Fed to meet monetary outflows. Banks must hold a certain amount of reserves, but the Federal Reserve Bank of San Francisco reports that banks typically hold more than required so they can clear checks and keep teller machines stocked with cash.