Target Rate: What It Is and How It Works

What Is a Target Rate?

A target rate is a key interest rate in an economy that the central bank uses to guide and gauge the effectiveness of its monetary policy. The target rate, which is also known as an operating target, is an intermediate target that the bank can directly influence by its monetary policy and which it understands to be related to downstream economic performance. 

Understanding Target Rates

Target rates are used to guide monetary policy, especially open market operations, to gauge how much money and credit to add or withdraw from the financial system to achieve the desired economic outcome. They are observable market phenomena that respond directly to central bank actions and are also tied to overall economic activity. 

The central bank adjusts its monetary policy to achieve the desired target rate, with the intent that this will be instrumental in achieving the rates of inflation, national income growth, and employment that are the bank's mandated goals.

Central banks set the target rate using a wide variety of tools. Target rates might be set solely on the insight and discretion of bank officials or by fixed rules, such as the Taylor Rule. A change in a target rate, such as the federal funds rate, can affect other short-term interest rates, longer-term interest rates, foreign exchange rates, stock prices, the amount of money and credit in the economy, employment, and the prices of goods and services.

Special Considerations

Target rates can be publicly announced or kept secret depending on the policy and intentions of the central bank. In the past, central banks like the Federal Reserve did not always publicize (and sometimes deliberately obfuscate) their policy target rates to prevent market participants from anticipating their moves.

This was based on theories from macroeconomics that only unanticipated changes in central bank policy would have much impact on gross domestic product (GDP) and employment.

In more recent times, central banks usually publish both their target rates and their forecasts and intentions for possible future adjustments to target rates, as part of a monetary policy tool known as forwarding guidance. Under forwarding guidance, rather than seeking to surprise market participants, a central bank attempts to shape market expectations to support overall monetary policy.

Federal Open Market Committee (FOMC) Target Rate

The Federal Open Market Committee (FOMC) uses the fed funds rate as its target rate. The fed funds rate is defined as the interest rate charged by one bank for an overnight loan of money stored at the Federal Reserve to another bank. A target range is sometimes designated by the FOMC along with the target rate during times of economic uncertainty. The target rate is often related to the risk-free rate in an economy.

The FOMC controls the target rate through open market operations (OMO), which involves the purchases and sales of securities, such as U.S. Treasuries, mortgage-backed securities, or other debt instruments in the open market. It is considered a target interest rate because the actual value of the rate will depend on the supply and demand for overnight lending in the open market.

However, because a bank demanding overnight reserves could borrow from the Fed itself at the discount window, the target rate tends to stay enforced.

The 12 members of the FOMC meet for eight regularly scheduled meetings per year. During these meetings, the FOMC reviews economic and financial conditions and determines the federal fund's target rate. The FOMC can lower its target if it wants to stimulate inflation or the flow of credit, or it can raise its target if it wants to fight inflation or slow credit markets down.

The FOMC may schedule additional meetings as necessary to implement changes in the target federal funds rate. At any of the FOMC's meetings, the federal fund's target rate may increase, decrease, or remain unchanged depending on the economic conditions in the United States. A target is typically tied to a particular inflation level that the central bank thinks is benign for an economy.

The Bottom Line

A target rate is an interest rate used by a central bank to influence monetary policy. A nation's central bank sets a target rate to influence other interest rates in an economy in an effort to contract or expand the economy depending on current market conditions.