The chief bank of the United States is the Federal Reserve Bank, comprising of a board of governors in the capital of the country and manages twelve reserve banks at district level. Being the chief bank of the country, it’s the responsibility of this bank to control the flow of funds and control country’s economy. Here we shall have a look at the Tools of the Federal Reserve Bank that empower it to do the needful when recessionary trends set in or inflation is on the rise.
1. Open Market Operations
The capacity of the Federal Reserve Bank to explicitly trade Treasury securities enables it to manipulate federal funds rate. This is the rate of interest that banks charge on lending money to each other for overnight. The reserve bank fixes a target rate and tries hard to maintain the same. When the rate of interest goes excessively high, banks don’t get encouraged to borrow funds and may fail to fulfill their short term requirements of funds. This could straightway have an effect on withdrawal and hence spending of money by consumers, which would in the long run harm macro economy of the country.
2. Overnight Lending
Under circumstances, leading the banks to get cautions of providing loan to each other, the Federal Bank may offer them overnight funds by way of loans. To facilitate speedy transfer of funds, these are generally offered by regional reserve banks. This type of funding doesn’t cause any change in money supply to economy as it is directed to fulfill short requirements of funds required by any bank. This kind of assistance has no bearing on the reserve rate and at times banks are apprehensive of borrowing straight from the Federal Reserve, fearing that it might harm their reputation.
3. Term Auction Facility
One of the other Tools of the Federal Reserve is the term auction facility that it uses to auction a predefined sum of credit with payback terms further than 24 hours. It allows banks to submit their proposition for availing loans. However, banks are needed to have a good record of financial stability and qualify for stipulated bid requirements. Bidding enables the Federal Reserve to have a more accurate idea of the likely amount of lending to the banks. Banks too are not so apprehensive of borrowing funds through auctions, compared to overnight borrowing.
4. Changing the Federal Funds Target Rate
Perhaps, of all the Tools of the Federal Reserve, the most significant is its right to modify the rate of target federal funds, whenever it sees a threat of profound recession or inflation going very high. As and when economic growth is required, the Federal Bank would generally lower the target rate to encourage liquidity of banks and prompt expansion of credit. Low target rate encourages borrowers to borrow additional funds. On the other hand, when the Federal Bank realizes that inflation has gone beyond a point, it enhances target rate, thus curbing borrowing and credit payments.