One main function of the Federal Reserve is to conduct monetary policy to achieve our congressionally mandated “dual mandate” objectives of maximum employment and stable prices in the U.S. The Federal Reserve controls the three tools of monetary policy – open market operations (Off-site), the discount rate (Off-site) and reserve requirements (Off-site). The Board of Governors of the Federal Reserve System is responsible for the discount rate and reserve requirements, and the Federal Operations Market Committee (FOMC) (Off-site) is responsible for open market operations. The FOMC consists of the seven members of the Fed's Board of Governors, the president of the Federal Reserve Bank of New York and four regional Reserve Bank presidents who serve on an annual rotation.
Using these three monetary policy tools, the Federal Reserve influences the demand and supply of balances that depository institutions hold at Federal Reserve Banks. In this way, it alters the federal funds rate to achieve the target range set by the FOMC. The federal funds rate is the interest rate at which depository institutions lend balances at the Federal Reserve overnight to other depository institutions.
Changes in the federal funds rate trigger a chain of events that affect other short-term interest rates, foreign exchange rates, long-term interest rates, the amount of money and credit, and ultimately, a range of economic variables, including employment, output and prices of goods and services.
In setting monetary policy, the FOMC seeks to mitigate employment shortfalls over time, based on the committee’s assessment of the maximum employment level and inflation deviations from its longer-run goal. Most of the time, the Federal Reserve’s goals for employment and inflation are complementary. However, the FOMC may face situations where its goals are pulling policy in opposite directions. In these circumstances, the committee considers the employment shortfalls and inflation deviations, as well as the potentially different time horizons over which employment and inflation are projected to return to their desired levels. If the FOMC determines that more accommodation is needed to achieve its goals, the committee will lower the federal funds rate target range. If the range is already at its effective lower bound, the FOMC has other tools it can use to provide additional accommodation. Conversely, if it determines less accommodation is required, the FOMC will increase the federal funds rate target range and may use its other tools to further tighten financial conditions.
To learn more about how the Fed functions, visit The Fed Explained: What the Central Bank Does (Off-site).