Over the last few years, the dominant global economic theme that we have come to be all-too familiar with has been the rampant inflation that has gripped countries around the world. This inflationary surge has led to a wide variety of goods and services to spiral out of control: everything from dining out at restaurants, purchasing used cars/rental cars, buying eggs, to acquiring patio furniture. These price escalations, along with the occasional scarcity of certain products, have taken a significant bite out of consumers’ disposable incomes.
In the effort to curb inflation, central banks both in the US and globally have taken decisive steps to tighten monetary policy with the goal of decelerating the pace of price increases. Specifically, in the US, the Federal Reserve has increased interest rates 11 times since March of 2022, including 3 times by a whopping three-quarters of a percent. These measures seemed to be working well until late 2023: Inflation figures came down from over 9.4% back in 2022 to just over 3% at the end of last year.
Even with inflation subsiding, the economy continues to hum along at a brisk pace. Strong employment, wage growth and housing prices that refuse to subside, tend to suggest that inflation is still a lingering concern and that interest rates may not be coming down as quickly as many economists had expected. The US economy is showing such continued strength that interest rate futures markets (what market participants feel the course of interest rates will be) are now indicating that rate reductions may be delayed until later this year and could potentially occur only 1 to 2 times. This is a significant shift from earlier expectations, where many economists were predicting that rates would be lowered 6 times in 2024, based on market consensus at the end of 2023.
So……how exactly does a central bank raise interest rates to curb inflation and regulate the economy? What tools does it have at its exposure to bump up lending rates with the goal of controlling inflation? For the sake of this article, we will use the US Federal Reserve as our primary example of how a central bank can affect monetary policy through 4 techniques: affecting what is called the federal funds rate through controlling bank reserve requirements and open market operations (selling of Treasury Bonds), as well as the discount rate. Overnight reverse repurchase agreements are another route which can be exercised, but discussion on this option is a bit beyond the scope of this article.
To begin, the main tool which the Federal Reserve uses to increase interest rates that we hear about in the financial press is what’s called the ‘federal funds rate’. The thing to remember is that the Federal Reserve initially attempts to increase this rate directly at the retail bank level, where we hold our deposits, mortgages, business loans and investments. This is done through two tactics: Increasing bank reserve requirements and open-market operations.
Let’s begin by discussing reserve requirements. Banks nationwide must adhere to the Federal Reserve’s mandate to retain a specific portion of their customer deposits as a form of ‘safety net’, or in other words, funds that they are not able to lend out. Banks can store these reserve requirements either within their own institution or in one of the 12 Federal Reserve banks across the country.
For instance, should the Federal Reserve decide on a reserve requirement of 20%, banks must maintain $200,000 of a $1,000,000 deposit in reserves, while being able to loan out the remaining $800,000. However, in scenarios where the economy and inflation are running above trend levels, the Federal Reserve holds the authority to increase this reserve requirement to say 30%. Following our scenario, this adjustment mandates the bank to set aside an additional $100,000, raising their reserve total to $300,000, compared to the initial $200,000. Consequently, the amount available for lending is reduced to $700,000 from the earlier $800,000.
This Federal Reserve strategy effectively compels banks to decrease the amount of money that they are able to extend as loans. Basic economic theory tells us that when the supply of a commodity decreases while demand remains constant, the price of that commodity will rise. In this context the ‘commodity’ is money, meaning the cost associated with money, or more precisely, interest rates.
This context introduces the concept of the federal funds rate. When banks must raise their reserve requirements, rather than holding these additional non-loanable funds on-hand earning very little return, the bank can choose to lend these funds to another bank who needs them to bolster their own reserve requirements. These short-term loans between banks are what is known by the federal funds rate (or the ‘overnight rate’), a rate determined by the Federal Reserve. Currently, the ‘target’ range for the federal funds rate is set between 5.25% and 5.50%.
Another strategy employed by the central bank to regulate the federal funds rate is called open market operations. When inflation is running high and interest rates need to be increased, the central bank can sell some of its inventory of Treasury securities to banks. This sale is facilitated by crediting the purchasing bank’s reserve account at the Federal Reserve. This process is known as quantatative tightening.
The quantatative tightening technique used in conjunction with the previously discussed reserve requirement, aims to reduced the availability of loanable funds and increase interest rates. When a bank purchases Treasury Bonds from the Federal Reserve, the bonds are paid for in cash which effectively withdraws that amount from a bank’s pool of loanable funds. Over the last two years, the Federal Reserve has sold a whopping total of $1,500,000,000,000 ($1.5 trillion) in Treasury bonds to banks in order to remove loanable funds from the economy.
Let’s explore a worse-case scenario in the banking system: What happens if bank customer deposits decrease so markedly across competing banks that a bank finds itself unable to secure short-term funds from another institution? In such situations, the bank may then be forced to borrow from one of the 12 regional federal reserve banks directly. This borrowing mechanism, known as the ‘discount window’ or ‘discount rate’, represents the fourth tool that the Federal Reserve has at its arsenal to raise rates.
Typically, the discount rate is the ‘rate of last resort’ as the Federal Reserve wants to encourage healthy lending between banks themselves to maintain their reserve requirements. Nevertheless, in order to adhere to its regulatory requirements, facilitate depositer withdrawals and originate new loans, a bank may be forced to borrow from the Federal Reserve directly if it is unable to secure funds from other banks. Consequently, the volume of borrowing directly from the Federal Reserve through the discount rate tends to be minimal, with the interest rate for this method maintained at a relatively high level.
