In Plain English: How Monetary Policy Normalization Would Take Hold

September 24, 2015

It’s widely known that the Federal Open Market Committee (FOMC) is considering "normalizing" monetary policy, or raising the target range for the benchmark federal funds rate. That rate is what banks charge each other for the billions of dollars they lend among themselves every day.

But the Committee's decision will not be a decree that automatically increases interest rates throughout the economy. Rather, monetary policy is "transmitted" through channels into the financial markets. Then financial institutions set rates at which they lend to each other—the federal funds rate—which in turn ripples through the financial system to influence rates on all manner of loans to consumers and businesses.

To move the fed funds rate toward the FOMC's desired target, the Fed employs various levers, many of which involve a unit of the Atlanta Fed and other regional Reserve Banks known as the credit and risk management (CRM) department. 

CRM performs "real central bank stuff"

During normalization, the Fed intends to move the fed funds rate into the target range primarily by adjusting the interest rate on money—reserves—that banks and other depository institutions keep in accounts at the Fed, according to the FOMC's Policy Normalization Principles and Plans. The Fed will also employ a backup tool known as overnight reverse repurchase agreements. But changing the interest rate on reserves will be the main means of normalizing policy.

Servicing those reserve accounts is CRM's work. "This is real central bank stuff," says Doris Quiros, assistant vice president in CRM at the Atlanta Fed.

The Atlanta Fed's CRM team is responsible for managing reserve accounts that most of the 1,500 depository institutions in the Southeast (Alabama, Florida, Georgia, and parts of Louisiana, Mississippi, and Tennessee) hold with the Atlanta Fed. Thus, as the likely time approaches to normalize monetary policy, the Atlanta Fed CRM team is preparing to wield a critical tool that will adjust the policy, says Mark Craig, a director of CRM at the Atlanta Fed.

It's a new tool. The Fed began paying interest on reserves in 2008 amid the central bank's efforts to nurse the economy and financial system through the financial crisis. The interest rate on reserves–both the reserves the Fed requires institutions to maintain and “excess reserves” that institutions choose to keep—has been unchanged at 0.25 percent since December 2008.

A push on short-term rates likely ripples through to longer-term rates

Paula Tkac

But as the FOMC's principles and plans state, the rate will likely change as part of policy normalization. Increasing the rate on reserves would put powerful upward pressure on short-term interest rates throughout the financial system, explains Paula Tkac, an Atlanta Fed vice president and senior economist who specializes in financial markets. That pressure would come from what economists call "opportunity cost."

Opportunity cost represents the value of the alternative one does not choose. So in this case if a bank can earn—for purposes of this illustration—1 percent for simply parking its money risk-free at the Fed, then surely it would charge more than 1 percent to lend it to another financial institution overnight (a fed funds transaction). After all, unlike leaving money in reserves, lending requires work, and there’s risk of not being repaid.

Even if the FOMC begins raising the federal funds rate target and short-term interest rates inch up, Fed economists like Tkac will remain busy analyzing another key element of monetary policy. How will a rise in short-term interest rates affect longer-term rates on credit such as consumer and general business loans?

As Tkac explains, since financial institutions and markets are so interconnected, by tweaking the future path for short-term rates, the Fed "effectively changes an important ingredient in the calculus underlying long-term rates."

"When an investor [or lender] thinks about the rate of return they need to receive to lock their money up for a longer period of time, they begin that calculation with a baseline forecast of where they believe the FOMC will choose to set short-term rates over that period," Tkac continues.

Investors will also consider how uncertain they are of the path of short-term rates. But if they think the path is now steeper, then they will likely raise their longer-term rates accordingly.

photo of Charles Davidson
Charles Davidson

Staff writer for Economy Matters