How the Federal Reserve Influences Interest Rates
January 18th, 2013 by David Waring
As we learned in our last lesson, the Federal Reserve has the ability to influence the economy by increasing or decreasing the supply of money. Their primary tool for doing this is by buying and selling Treasuries, a process which is known as “open market operations”.
When the Fed wants to raise interest rates
Money that is held at the Federal Reserve is essentially taken out of circulation. When the Fed sells Treasuries, the buyer is giving the Fed cash and getting a Treasury Bond. The cash which would normally be placed at bank and loaned out is now effectively out of circulation, reducing the supply of money, which makes borrowing money more costly (meaning interest rates go up).
When the Fed wants to lower interest rates
They create new money which is not currently in circulation, and then use that money to buy Treasury Bonds. As the money they are using to buy Treasuries is new money, this increases the supply of money, which makes borrowing less costly (meaning interest rates go down).
The process by which the Fed decides what course of action it is going to take regarding the money supply, and how they go about it, is what is referred to as Monetary policy.
As they enact monetary policy the Fed watches interest rates on a variety of different instruments with varying maturities (like short term bonds, long term bonds, rates on home loans etc). Where they look first however is short term rates as defined by the following:
The Fed Funds Rate
The name “Fed Funds” rate is a bit misleading because the Fed Funds rate is the average interest rate rate which one bank charges another for a loan that is made for 1 day (also referred to as “overnight”).
To assist with their primary function of lending money, banks will also borrow money from other banks. This happens quite frequently, especially on a short term basis in order to cover immediate cash needs. Overnight lending between banks is at the very center of the economy, which is why there is a lot of emphasis placed on the level of the Fed Funds Rate. When the Fed Funds rate moves higher, the increase reverberates throughout the rest of the economy through higher rates on everything from credit cards to car loans.
The Fed Funds Target Rate
The Federal Reserve has a goal for the Fed Funds Rate, which they seek to meet through “open market operations”, which is the buying and selling of treasury bonds. The Fed Funds Target Rate is is set by the Federal Reserve’s Open Market Committee (FOMC) which meets and votes on monetary policy (including what their target for the Fed Funds rate will be) 8 times per year.
After each meeting, any changes to the Fed Funds Target Rate, as well as the Fed’s outlook for the economy are released in what is known as the “FOMC Statement”. (see an example here).
As influencing the Fed Funds Rate is not an exact science, the Fed Funds Target Rate is set as a range. As of November 2nd, 2011, the range for the Fed Funds Target Rate was between 0.00% and 0.25%.
When you hear someone say the Fed has raised or lowered interest rates, the Fed Funds Target rate is what they are referring to.
The Discount Rate
The Discount rate is the rate at which banks can directly borrow money from the Fed to meet their legal reserve requirements. Borrowing from the Fed carries an enormous stigma, as it implies that you cannot find other banks to lend you money. While the Discount rate is often reported alongside the Fed Funds and Fed Funds target rate, from a monetary policy and therefore a market standpoint, it carries a much lower significance.
This lesson is part of our Free Guide to the Basics of Investing in Bonds. Continue to the next lesson here.
