Banks and Monetary Policy

The Mechanics of Interest Rates Setting(By Luigi Frascati)

We hear a lot about interest rates, and not only in my professional field of expertise. Interest rates are everywhere to be found in our daily lives: credit card interest, interest on deposits, car loan interest, personal loan interest, treasury bond interest. The other day I received a spam e-mail that said: "Need new socks ? Apply for our Family Loan - competitive interest rates". Since I am single and own approximately fifty pairs of socks - they seem to be the preferred Christmas present in my household - I decided not to push the 'Click Here' button. But just what are the mechanics of interest rate setting? Who decides which interest rate to charge to whom - and how?
Paul Volcker, while chairman of the Board of Governors of the Federal Reserve System (1979-87), was often called the second most powerful person in the United States. Volcker triggered the "double-dip" recessions of 1979-80 and 1981-82, vanquishing the double-digit inflation of 1979-80 and bringing the unemployment rate into double digits for the first time since 1940. Volcker then declared victory over inflation and piloted the economy through its long 1980s recovery, bringing unemployment below 5.5 percent, half a point lower than in the 1978-79 boom and helping Ronald Reagan convert the American people to Reaganomics. Volcker was powerful because he was making monetary policy. Central banks are powerful everywhere for the same reason, although few are as independent of their governments as the Fed is of Congress and the White House. Central bank actions are the most important government policies affecting economic activity from quarter to quarter or year to year.
Monetary policies are technically demand-side macroeconomic policies. They work by stimulating or discouraging spending on goods and services. Economy-wide recessions and booms reflect fluctuations in aggregate demand rather than in the economy's productive capacity. Monetary policy tries to damp, perhaps even eliminate, those fluctuations. It is not a supply-side instrument. Central banks have no handle on productivity and real economic growth. A central bank is a "bankers' bank." The customers of the Federal Reserve Bank are not ordinary citizens but "banks" in the inclusive sense of all depository institutions--commercial banks, savings banks, savings and loan associations, and credit unions. They are eligible to hold deposits in and borrow from the Federal Reserve System and are subject to the Fed's reserve requirements and other regulations. The same relationship exists in Canada between the Bank of Canada and the individual banking institutions.
Banks are required to hold reserves at least equal to prescribed percentages of their checkable deposits. Compliance with the requirements is regularly tested, every two weeks for banks accounting for the bulk of deposits. Reserve tests are the fulcrum of monetary policy. Banks need "federal funds" (currency or deposits at Federal Reserve System) to pass the reserve tests, and the Fed controls the supply. When the Fed buys securities from banks or their depositors with base money, banks acquire reserve balances. Likewise the Fed extinguishes reserve balances by selling Treasury securities. These are open-market operations, the primary modus operandi of monetary policy. A bank in need of reserves can borrow reserve balances on deposit in the Fed from other banks. Loans are made for one day at a time in the "federal funds" market. Interest rates on these loans are quoted continuously. Central Bank open-market operations are interventions in this market. Banks can also borrow from the Federal Reserve Bank at the announced discount rate. The setting of the discount rate is another instrument of central bank policy. Nowadays it is secondary to open-market operations, and the Fed generally keeps the discount rate close to the federal funds market rate. However, announcing a new discount rate is often a convenient way to send a message to the money markets.
How is the Fed's control of money markets transmitted to other financial markets and to the economy? How does it influence spending on goods and services? To banks, money market rates are costs of funds they could lend to their customers or invest in securities. When these costs are raised, banks raise their lending rates and become more selective in advancing credit. Their customers borrow and spend less. The effects are widespread, affecting businesses dependent on commercial loans to finance inventories; developers seeking credit for shopping centers, office buildings, and housing complexes; home buyers needing mortgages; consumers purchasing automobiles and appliances; credit-card holders; and municipalities constructing schools and sewers. Banks compete with each other for both loans and deposits. Because banks' profit margins depend on the difference between the interest they earn on their loans and other assets and what they pay for deposits, the two move together. Thanks to its control of money markets and banks through monetary policy, the Fed influences interest rates, asset prices, and credit flows throughout the financial system. Arbitrage and competition spread increases or decreases in interest rates under the Fed's direct control to other markets including, of course, real estate.