Question

Why has the Federal Reserve chosen to focus on the federal funds rate rather than some other interest rate as a tool of monetary policy?

Answer 1

In America, the banks has to keep certain amount with the Federal Reserve as reserve requirement. This is mandatory requirement. Some times banks might need extra funds to maintain this reserve requirement. They borrow this amount from other banks. The interest rate charged on these loans are called federal fund rates.

Why is federal fund rate important?

Federal fund rate is an important monetary policy tool. Federal open market committee (FOMC) is responsible for fixing the above mentioned rate. They do so through open market operations. The decisions on Federal fund rates, i.e whether to increase or decrease the rate, is made up on how the economy is progressing. Suppose the economy is facing inflationary pressure. To reduce inflation in the economy the FOMC increases the Federal fund rates. This discourage banks from taking loans, which makes credit hard to come by. The banks then increase their prime lending rates, making bank loans much costlier The opposite happens during recession.

Credit card rates - As seen in the above example, Federal fund rates has an impact on prime lending rates. The interest rate on credit card is based on prime lending rates, which in turn is influenced by the federal fund rate. So a change in federal fund rate can influence how consumer make expenditure.

Savings and CD rates - lower the federal fund rates, lower will be interest received on savings account and CD rates.

Mortgage rates - Federal fund rate has less of an impact on mortgage loan rates. This is because of existence of time lag the monetary policy has on the economy and also because mortgage rates are linked to 10 year treasury bills.

Home equity line of credit (HELOC)- mortgage rates are variable.  HELOC is linked to prime lending rates. i.e HELOC rates will fall when federal fund rate changes and vise versa.