You can see now that if the Fed can control the volume of bank reserves, it can influence the level of economic activity and interest rates. How does the Fed alter the level of bank reserves throughout the banking system? The answer is that the Fed conducts Open Market Operations, which means that the Fed buys and sells government securities (bills, notes, and bonds) on the open U.S. government securities market. Visualize what happens if the Fed decides to buy bonds, say from a pension fund, or from anyone in the non-bank public. To buy a $1 million Treasury bond, the Fed must write out a check to the bond seller. What does the bond seller do with the check? Most likely, the seller deposits the check in a bank. Now you can complete the sequence. The bank now has $1 million in new deposits and, if the required reserve ratio is 10%, it has $900,000 in excess reserves, which it can loan. And so the money creation process begins.
What if the Fed sells bonds? Then, a sequence opposite to that just indicated in the preceding paragraph occurs. Bond buyers must now write a check to the Fed, instead of getting a check from the Fed. When a bond buyer writes a check, bank deposits fall, excess reserves fall, and ultimately the volume of total reserves falls by a multiple of the initial decline in deposits caused by the bond buyer who wrote out a check to pay for the bonds purchased.
The volume of excess reserves has a special name. Such reserves are called federal funds, or as they are more commonly known by their abbreviation, fed funds. Don't be misled and think these funds are federal funds that belong to the federal government. The term fed funds is the name for all of the excess reserves held by banks. Since the Federal Reserve influences the volume of excess bank reserves by open market operations in buying and selling government securities, excess bank reserves are called fed funds. Fed funds are owned by banks not the federal government.
Just as many different interest rates exist, there is a special interest rate for fed funds known, not surprisingly, as the fed funds rate. The larger the volume of fed funds, the lower will be the fed funds rate (just like the price of corn falls after a bumper crop). Thus, the more bonds the Fed buys, the more checks it writes out and the greater will be the volume of total reserves, required reserves, and excess reserves. The more bonds the Fed sells, the more all bank reserves shrink, including fed funds (the excess reserves).
The Fed's Open Market Committee meets approximately every five or six weeks to debate what course the Fed should take in influencing interest rates. Note that we said "influencing" rates; many people mistakenly think the Fed sets rates. The Fed can influence rates by buying and selling bonds. What happens next depends on choices made by banks and depositors.
The final step in this preliminary Fed watching exercise is to note that fed funds (excess reserves) can be loaned out. That is, a bank that is short of required reserves can make up the deficiency with a short-term (probably overnight) loan, which it borrows in the fed funds market. If the volume of fed funds (excess reserves) is large, the fed funds rate will be low. Thus, if the Fed wishes to lower the fed funds rate, it will buy bonds and pump more money into the banking system.
The fed funds rate is a beacon for other interest rates. If the fed funds rate rises, banks will probably raise the prime rate (the rate that banks charge their best commercial customers); credit card rates and mortgage rates and other rates will also rise. Then businesses will borrow less money, create fewer new projects, and output will fall. Higher mortgage rates mean fewer people can afford housing so fewer houses will be built, fewer loans will be made, and all the businesses tied to the housing industry will shrink.
As you begin watching the Fed, you should be tracking the actions that the Open Market Committee takes to influence the fed funds rate. The economy follows the fed funds rate. You can find a wealth of information, including minutes of recent Federal Open Market Committee meetings on the Internet site for the St. Louis Fed. You should check The Wall Street Journal regularly to track the current fed funds rate. The rate is listed under "Money Rates," usually on the same page as the Credit Markets Report. Note that if the Fed seeks a particular fed funds rate, say 5.5%, the actual market rate for fed funds (excess bank reserves loaned by banks to one another) will likely fluctuate by several tenths of a point above or below the 5.5% mark. The Fed staff at the New York Fed's Open Market trading desk constantly watches the prevailing market rates to see if they must take any offsetting actions to try and keep the actual fed funds rate as close to the target rate as possible.
Now your assignment is to begin watching the Fed by reading newspaper articles about interest rates and about likely future Fed actions concerning the fed funds rate.