US Federal Reserve System (shortly FED) impact US economy basically by two interest rates: discount rate (primary credit rate) and fed funds rate. FED directly settles discount rate but fed funds rate it can influence indirectly through operations in the open money market. It works in the following way: commercial banks are obliged to hold a certain part of  the money held by society onto their accounts and if a bank do not have enough liquidity it can borrow some excess of reserves from another bank. This is a fed funds trade.

The interest rate which debtor has to pay is settled by the lender. Where is FED? Why should the bank ask only 0.1% and not 10%? FED as previously was said cannot directly influence this rate but Reserve System has an idea where to move the market, what rate must be good for economy. Such rate is called the Target Fed Fund Rate. But the real rate which banks pay to each other is called an Effective Fed Fund Rate. And the goal of Federal reserve System is to move effective rate to the target rate.

Federal Reserve System’s (FED’s) interest rate impact scheme

Banks hold some money as reserves. However, the amount of reserves held on FED’s account by the banks is more than the required one (the extra reserves are called excess reserves). For example, a bank may hold $1 billion although it is required to hold only 500 million. Bank is ready to hold more money there because it gets interest for it.

US Treasury issue bonds and part of this bonds is held by Federal Reserve System on SOMA (System Open Market Account Holdings). If Fed wants to increase the effective fed fund rate it will through bonds from SOMA into the market. Bonds will give higher return and the same level of risk as excess reserves. Therefore banks will buy this bonds and the amount of excess reserves will decrease which will impact the effective fed fund rate by making it grow. Before year 2008 it worked really well.

All these doings by FED have sense for the economy because making money cheap using discount rate (primary credit rate) and fed funds rate, FED gives banks an opportunity to lend money to people and companies for a lower interest rates. Cheaper loans – more loans – more loans – higher economic activity.

Since year 2008, Fed made an enormous amount of reserves which now is more than $1.5 trillion.

Several articles written by Glebs Kabanovs were used.