In every country, there is a system that governs the monetary policy of the country to ensure that the market cycles do not transform themselves into runaway trains. In the United States, it is the Federal Reserve and one of the options the Federal Reserve has is the Federal Funds Target Rate.
To understand this, let’s first delve a bit into the background of banking.
Banks accept deposits and lend money. But in order for them to remain afloat, the Federal Reserve obligates each bank to deposit a portion of their lending capacity as a Liquidity Reserve to ensure that they will be able to pay back their depositors even if their loans and investments go bad.
Banks also lend and borrow from each other and the primary lender is the Federal Reserve itself and fixes a lending rate from time to time depending on the economic condition as well as the inflation rates in the country.
The Federal Open Market Committee which is responsible for the maintenance of economic stability by liquidity control performs Open Market Operations from time to time as required to ensure that there is enough liquidity in the market, yet not enough to cause the inflation to go high.
Typically as seen in the recent times since the slowdown, the Federal Open Market Committee reduces the Federal Funds Target Rate and reserves ratio to increase the lending capacity of banks by pumping in funds into the economy.
This is done by reducing the percentage of the reserves in deposits and vault cash required of banks. This results in surplus cash with lending back which they lend to individuals and institutions, resulting in greater liquidity in the market.
The Federal Funds Target Rate when reduced allows banks to borrow at a lower rate, which increases their lending capacity. For example, if the Federal Funds Target Rate is at 10% and is reduced to 9%, the banks that lend at a hypothetical rate of 14% will be able to make a greater profit on their loans when they can borrow at 9%. This further encourages banks to lend more, thereby increasing the liquidity in the market.
These are Open Market Operations performed during an economic slowdown or a recessionary trend in the markets.
On the other hand, when inflation rises and tends to overwhelm the economy, the Fed normally increases the Federal Funds Target Rate and the reserve ratio to curb bank lending and might also increase the yield levels on treasury bills and government deposits to limit the liquidity in the market and encourage lesser spending by individuals and institutions alike.
The Federal Funds Target Rate is usually reviewed quarterly or half yearly after the economic survey is conducted to assess the health of the Nation’s economy.