Question

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 regularly scheduled Federal Open Market Committee, increases or decreases interest rates. That's the Federal Reserve Banking System's monetary policy arm. After the analysis of current economic data, the FOMC sets a target for the fed funds rate. The rate of fed funds is the interest rate charged for overnight loans between banks. Such loans are referred to as fed assets. Banks use these funds every night to meet the requirement of the federal reserve. If they have insufficient reserves, they will borrow the necessary fed funds.

If the Fed wants to lower the fed funds rate, bonds are withdrawn from the bank's reserves and replaced by credit. It's just like a bank's money. The bank now has more than enough funds to meet its requirement. To lend the extra reserves to other lenders, the bank reduces its fed funds rate. To get rid of excess reserves, it will drop the rate as low as possible. It would prefer to lend it a few dollars, rather than sitting on its ledger receiving nothing.When the Fed wants to raise prices, it does the reverse. This attaches securities to the assets of the bank and reduces credit. The bank now has to borrow fed funds to ensure that it has enough on hand to meet that night's reserve requirement. If enough banks borrow, it will raise the fed funds rate by those who can lend extra fed funds.

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