Question

The Fed has announced a new, lower target for the federal funds rate; in other words the Fed wants to lower the federal funds rate from its present level. What does setting a lower target for the federal funds rate have to do with open market operations?

Answer 1

The Federal Reserve uses open market operations to meet its target federal funds rate, buying Treasury bonds to inject liquidity and lower interest rates to stimulate economic activity.

Step-by-step explanation:

When the Federal Reserve (the Fed) sets a lower target for the federal funds rate, it is signaling its intention to stimulate economic activity. This lower target is achieved through open market operations, which involve the buying of U.S. Treasury bonds. By purchasing these bonds, the Fed adds to the money supply by increasing bank reserves.

This increase in reserves typically leads to a decrease in short-term interest rates, including the federal funds rate, which is the rate banks charge each other for overnight loans.

The relationship between the federal funds rate and open market operations is integral; as the central bank buys bonds, it injects liquidity into the banking system, making loans between banks cheaper and encouraging borrowing and spending in the broader economy.

Since 1995, the Fed has set its target federal funds rate in advance of these operations to provide clear guidance to the market. This approach is a key part of the Fed's monetary policy toolkit and is used to manage the economy's growth and control inflation by influencing the cost of borrowing money.