Most taxpayers know the Federal Reserve Board of Governors meets periodically to set interest rates, but too often, they leave the deeper analysis to economists. Since monetary policy affects the economy’s health and stability, everybody—including electrical contractors—should be familiar with how these decisions are made.


The federal government determines fiscal and monetary policy. Fiscal policy includes decisions on taxation and spending levels and priorities. Monetary policy, by definition, refers to actions by a country’s central bank that influence the availability and cost of money and credit to achieve specific national economic goals. In the Federal Reserve Act of 1913, Congress established several objectives to guide U.S. monetary policy: moderate long-term interest rates, maximum employment and stable prices. 


The three main components of the Federal Reserve System are the Board of Governors, the 12 Federal Reserve Banks, and the Federal Open Market Committee (FOMC). The seven members of the Board of Governors, including the secretary of the treasury and the comptroller of the currency, are nominated by the president and confirmed by the Senate. The Federal Reserve district banks form the system through which all checks are cleared and lending between banks occurs. The Board of Governors, plus rotating representatives from each of the districts, comprises the FOMC.


The Fed uses three primary tools to implement monetary policy. The buying and selling of government securities (treasury bonds, notes and bills), known as open market operations, is used most often and falls under FOMC control. It buys securities when it wants to increase the flow of money and credit and sells them when it wants to reduce the flow. Credits to a bank’s reserve or dealer’s account pay for purchases from that bank or dealer.


The bank must keep a portion of that credit in reserve but can lend the excess to another bank in the federal funds market, increasing the amount of money in the banking system and, through the laws of supply and demand, lowering the interest rate. Because banks have more money to lend, this action stimulates the economy by increasing business and consumer spending. Any increase in the supply of goods or services beyond their demand causes a reduction in the price—in this example, the interest rates on loans.


The Board of Governors controls the other two tools: reserve requirements and discount rate. Reserve requirements are set to provide a cushion against bank failure, ensuring a portion of the bank’s total deposits (in excess of the amount loaned out) is maintained, either as cash in the vault or on deposit at a Federal Reserve Bank. The reserve requirement is approximately 10 percent of deposits.


If a bank’s reserves fall below the required amount, the bank can borrow funds overnight. These “federal funds” are borrowed directly from the Federal Reserve Bank or from deposits from other banks at the Federal Reserve. The discount rate is the interest charged by the Federal Reserve for lending its own funds. The federal funds rate is the interest charged by another bank for lending its deposited funds.


Here is how it works. Big Bank has $100 million in customer deposits and outstanding loan balances of $90 million. Therefore, $10 million is available to cover daily transactions. If many customers want to withdraw their money on the same day, there may be a shortfall of cash, triggering a bank failure. If this also happens at other banks, it can snowball and affect the entire economy.


Big Bank calculates its deposit and outstanding loan balances each day. If it has insufficient reserves to meet the requirements, it borrows Fed funds overnight. If the loaned funds are from another bank, it pays the Fed funds interest rate to that bank. If it borrows directly from the Federal Reserve Bank’s own funds, it pays the discount rate. The next day, Big Bank may have excess reserve funds, and it may lend funds deposited at the Federal Reserve Bank to another bank with a shortfall, earning the Fed funds’ interest rate for that overnight loan.


The Fed uses the discount rate to influence other interest rates. If it wants to stimulate the economy, it announces a lower discount rate, which causes banks to reduce the Fed funds rate they charge each other.


Variances in the Fed funds interest rate cause a ripple effect on short- and long-term interest rates, foreign exchange rates, available credit and the money supply. These ripples extend to economic indicators such as employment levels, production output and the prices of goods and services. Next month’s column will explore those factors further.