IV.

Monetary Control

The Fed is best known to the public for the influence it has on interest rates by “loosening” or “tightening” the money supply. The term money supply has various technical definitions (see Money), but basically it is the amount of currency, coin, and checking account balances available at any one time in the U.S. financial system. The interest rate that Fed policymakers focus on primarily is the federal funds rate, the interest rate at which banks lend money to other banks that need to make loans.

The Federal Reserve's open market operations are the most flexible and most frequently used instrument of controlling the money supply and the federal funds rate. When the FOMC decides that the money supply is growing too slowly to meet the economy’s needs or that interest rates are too high, the Fed purchases U.S. Treasury securities on the open market—that is, from the public and banks—thus injecting cash into the financial system and expanding bank reserves and lowering the federal funds rate. This process enables banks to loan more money, which helps businesses and consumers and helps the economy grow faster. Conversely, should the money supply or economy grow more rapidly than is desired or should interest rates be too low, which may lead to inflation (a sustained increase in prices), the FOMC will sell securities of the Department of the Treasury on the open market. Such sales reduce bank reserves and raise the federal funds rate and thus slow down the economy. Generally, this reduces the money supply and protects against inflation.

Although the open-market operation is the most flexible and the most frequently used instrument of monetary policy, similar results can be achieved by changing the required reserve ratio—that is, the percentage of deposits that banks must maintain on reserve as cash deposits at the Federal Reserve banks. When the required reserve ratio is raised, banks are unable to create as much money as they previously were able to because a larger portion of their assets must be held in reserve; the converse is true when the reserve ratio is reduced.

Also among its general controls, the Federal Reserve can make changes in the discount rate, the rate of interest at which the Fed lends money to banks. By raising the discount rate, the Fed discourages banks from borrowing money from the Fed. The Fed does this typically when it wants to reduce the money supply and slow the economy. Conversely, to increase the money supply and expand the economy, the Fed lowers the discount rate. A discount rate change may, at times, reinforce open-market operations. It may also, at times, have an “announcement effect,” signaling a change in the Federal Reserve's underlying evaluation of economic conditions.

The Federal Reserve also has a narrow role in regulating operations of the stock market. It may selectively lower or raise the margin requirement, which is the percentage of a stock price that must be provided in cash by someone who buys the stock on credit. The margin requirement, a legacy of depression legislation, aims to curb market speculation.

The Credit Control Act of 1969 authorized the U.S. president to give additional controls to the Federal Reserve. In 1980 the act was used as a means of controlling various types of consumer credit. The Gramm-Leach-Bliley Act of 1999 gave the Fed regulatory authority over the new financial services holding companies. These companies can offer banking, issue securities (stocks and bonds) and insurance, and other financial services all “under one roof.” The Glass-Steagall Act of 1933 had prohibited banks from engaging in many of these activities, such as underwriting securities and insurance, because they were deemed risky at the time.