Question

• Under what circumstances would the FOMC raise the federal funds rate? Why would the FOMC lower the rate? What does the Federal Reserve do to influence the federal funds rate?

Answer 1

The Federal Open Market Committee would increase the federal fund rates when economic growth is robust, the unemployment rate is at or below the natural rate of unemployment and the inflation is above the target inflation rate of 2%. In other words, the FOMC increases the federal fund rate when the threat of inflation is high or the economy is already in an inflationary boom ( inflationary gap).

On the other hand, when economic growth is sluggish, unemployment is trending higher and inflation is declining, the FOMC reduces the federal fund rate. In other words, the reduction in federal fund rate is when the economy is in a recession ( a recessionary gap).

The Federal Reserve conducts open market purchase and sale of bonds to influence the federal fund rate.

When the federal reserve wants to lower the federal fund rate, the central bank buys bonds from the open market. Banks and financial institutions sell bonds to the federal reserve and liquidity is infused in the banking system. With ample liquidity in the banking system, the federal fund rate declines, which is the rate at which banks lend to one another on an overnight basis. It is important to note that as the federal fund rate declines, the cost of funds for the banks declines and the interest rate in the economy also declines. At lower interest rates, consumers and businesses are more willing to pursue leveraged consumption and investment spending. This triggers economic growth.

When the federal reserve wants to increase the federal fund rate, the central bank sells bonds in the open market. Banks and financial institutions buy the bonds and liquidity is absorbed by the federal reserve from the banking system. As liquidity becomes tighter, the banks increase their cost of lending to other banks ( federal fund rates) . Therefore, tight liquidity in the banking system translates into increase in federal fund rates and this results in an increase in interest rates in the economy.