What Is an Operating Target?
Key takeaways
– An operating target is a specific, observable financial variable (usually an interest rate or reserve metric) that a central bank aims to hit to guide monetary policy. (Investopedia)
– Central banks cannot directly control outcomes like inflation or GDP in real time, so they choose operating targets they can directly influence and that are correlated with those ultimate goals.
– The U.S. Federal Reserve commonly uses the federal funds rate and related reserve quantities as operating targets, implementing them with open market operations and public guidance. (Board of Governors of the Federal Reserve System; Investopedia)
Understanding an operating target
An operating target is an intermediate, operationally useful variable that a central bank sets and attempts to maintain so that its actions transmit to broader economic goals (price stability, employment, growth). Because ultimate outcomes (inflation, GDP) are lagged, noisy, and not directly controllable, the central bank selects a target it can:
– observe frequently and reliably,
– directly influence with policy tools, and
– expect to be causally linked or strongly correlated with the ultimate policy objectives.
Common operating targets include short-term interbank interest rates (for example, the fed funds rate in the U.S.), the quantity of bank reserves, or other liquidity measures. The chosen target functions like a speedometer for a driver: it tells policymakers how aggressively to add or drain liquidity (depress or release the “throttle”) to reach their destination—healthy, stable economic growth—without overheating or stalling the economy.
How a central bank uses an operating target
1. Select the operating target that best links to policy goals (e.g., an overnight interest rate or reserve aggregate).
2. Set the specific numerical target or target range for that variable at policy meetings.
3. Use monetary policy tools (open market operations, standing facilities, reserve requirements) to move the target variable toward the chosen level.
4. Monitor market behavior and economic indicators continuously.
5. Adjust the target, the implementation approach, or communication (forward guidance) as new data arrive.
The central bank’s daily implementation focuses on adjusting liquidity so the market price (e.g., the interbank overnight rate) trades at the intended level. The central bank also uses public announcements and forward guidance to shape expectations, which in turn affects financial conditions and economic behavior. (Investopedia; Board of Governors of the Federal Reserve System)
Adjusting the money supply: practical mechanics
– To loosen monetary conditions (lower the short-term rate): the central bank buys government bonds or other eligible assets in open market operations, adding reserves to the banking system. More reserves make overnight lending cheaper, helping push the interbank rate down.
– To tighten monetary conditions (raise the short-term rate): the central bank sells government bonds, draining reserves from the banking system and making overnight funds scarcer and more expensive.
– The central bank can also use standing lending/borrowing facilities and reserve requirements to adjust the supply/demand balance in money markets.
The Fed’s operating targets and tools
– The Federal Reserve’s primary operational focus in normal times has been the federal funds rate (the overnight, unsecured lending rate between depository institutions). The Fed’s Open Market Desk conducts permanent open market operations (PMOs) and other operations to supply or drain reserve balances to steer the fed funds rate to the announced target or target range. (Board of Governors of the Federal Reserve System; Investopedia)
– The Fed also uses communication tools—announcement of target changes, forward guidance, minutes, and press conferences—to manage expectations about future policy and make the chosen operating target more effective.
The federal funds rate as an operating target
– Why the fed funds rate: it is a short-term market price that influences broader interest rates (consumer loans, mortgages, corporate borrowing), financial conditions, and ultimately spending, investment, and inflation.
– Implementation: After setting a target rate, the Fed engages in open market operations (buying to add reserves or selling to drain reserves) and uses standing facilities (discount window, overnight reverse repurchase agreements, interest on excess reserves when applicable) to keep the effective fed funds rate near the target.
– Communication: The Fed’s public announcements and forward guidance help align market expectations with the desired policy path, reinforcing the operating target’s transmission to the wider economy.
Practical steps — for central banks (implementation checklist)
1. Define the policy objectives (e.g., inflation target, employment goals).
2. Choose an operating target tied to those objectives and that is operationally controllable (e.g., short-term interest rate, reserve quantity).
3. Announce the numeric target or target range clearly and explain the policy rationale.
4. Use open market operations and standing facilities to supply or drain liquidity so the market variable trades at the target.
5. Monitor market conditions and economic indicators continuously; adjust operational tools or the target as necessary.
6. Communicate changes and the expected path of policy to shape public and market expectations (forward guidance).
7. Publish minutes and supporting analysis to maintain transparency and credibility.
Practical steps — for market participants and analysts (how to interpret operating targets)
1. Track official announcements: policy meeting statements, press conferences, minutes, and the Fed’s policy dot plot or equivalents.
2. Watch the central bank’s operating target (e.g., fed funds target/range) and the effective market rate (effective federal funds rate) to see whether implementation is tight or loose.
3. Monitor central bank balance sheet operations and open market operation calendars—these show how reserves are being added or drained.
4. Follow forward guidance and changes in the language of official statements—shifts can signal future changes in the operating target.
5. Use economic indicators (inflation, employment, GDP, labor markets) to form a view on future adjustments to the operating target.
6. Position portfolios for possible changes in short-term rates and their likely effects on longer-term yields, credit spreads, and growth-sensitive assets.
Risks and limitations
– Operating targets are intermediate and depend on stable relationships between the chosen variable and ultimate goals. If these relationships weaken (e.g., due to financial innovation, regulatory changes, or structural shifts), the effectiveness of the target may decline.
– Misjudging the appropriate level of the operating target can create inflationary pressures (if too loose) or slow growth/deflationary pressures (if too tight).
– Markets can sometimes test the central bank’s ability to supply or absorb reserves, requiring adjustments in tools, communication, or the operating framework itself.
Conclusion
An operating target gives a central bank a concrete, controllable gauge to implement monetary policy in pursuit of broader economic goals. By choosing an observable variable that can be directly influenced—most often a short-term interest rate—the central bank steers liquidity and expectations through market operations and communication. For both policymakers and market participants, clear implementation steps and transparent communication are essential for the operating target to effectively translate into the ultimate objectives of price stability and maximum sustainable employment.
Sources
– Investopedia. “Operating Target.” Accessed from https://www.investopedia.com/terms/o/operational-target.asp
– Board of Governors of the Federal Reserve System. “Open Market Operations.” Accessed July 2, 2021.