Does the Fed actually set interest rates?
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Listener Linda Hassberg from Lake Ronkonkoma, New York, asks:
My economist husband states that the Federal Reserve does not actually set interest rates. Instead it manipulates financial markets by buying and selling government securities which in turn influences interest rates offered by banks on deposits and loans. Please explain.
The Federal Reserve got some welcome news Friday: Its preferred inflation gauge showed prices rising more slowly, just 0.1% from May to June and 2.5% annually, which means that the central bank may cut interest rates in September.
The Fed has a dual mandate: to maximize employment and keep inflation stable at 2% (a target that is up for debate, but that’s another story). The central bank controls prices through monetary policy, influencing the supply of money and cost of borrowing. Fed officials decide whether to use those tools at the Federal Open Market Committee, which meets every six weeks or so.
The Committee’s decision reverberates throughout financial markets and trickles down to everyday consumers. “Interest rates are nothing but the price of money, and the Federal Reserve helps influence the price of money,” said David Bieri, an associate professor of economics at Virginia Tech.
Consumer prices began rising during the pandemic, reaching a peak of 9.1% year over year in June 2022. To pump the brakes on the economy, the Fed began to raise interest rates. Higher interest rates tend to depress spending, keeping inflation at bay.
The Fed will lower rates to stimulate the economy, which it did during the start of the pandemic. Demand and spending should go up.
Interest comes in many forms, like your credit card interest rate or your 30-year mortgage, but when we say the Fed “raises rates,” we’re really talking about the federal funds rate, because it influences all others.
“It’s the one rate that rules them all,” Bieri said.
The last time the Fed changed rates was back in July 2023, raising it by 25 basis points (one-hundredths of a percent) to bring the federal funds interest rate between a range of 5.25% to 5.5%, a 23-year high.
“It’s a corridor. It’s not a given rate. This is a target corridor where it wants its policy rate to be,” Bieri said.
That rate is crucial to the day-to-day business of banking. The federal funds rate isn’t paid by regular people; it’s the interest that banks charge to other banks when they’re lending additional reserves overnight. Commercial banks have to park a fraction of deposits at the Fed for safekeeping.
The Fed pays interest on the reserves that these banks keep at the Fed. It’s known as the interest on reserve balances rate, or the IORB rate, and the Fed adjusts that rate in order to steer the funds rate toward its target.
Say the federal funds rate is 2% and the IORB rate is 5%. Banks may borrow in the federal funds market at that low 2% rate, then deposit the money with the Fed to take advantage of that 5% rate. They pocket that 3% differential. The demand for funds from the federal funds market will go up, pushing up the federal funds rate.
But say it’s the reverse, and the federal funds rate is 5% and the IORB rate is 2%. Banks will borrow money from the Fed and lend it on the federal funds market. The increase in supply will lower the federal funds rate.
These transactions continue until the gap between the IORB rate and the federal funds rate closes. So when the Fed lowers the IORB rate, the effective federal funds rate will eventually go down. And vice versa.
The Fed also influences the federal funds rate with repurchase transactions, Bieri said. These are short-term agreements in which the Fed will buy Treasury securities with the promise to return them in the future. That increases liquidity in the system, which helps lower the federal funds rate. When there’s more money to go around, the cost of borrowing goes down.
In a reverse repurchase agreement, the Fed sells securities and buys them back at a future date. And that decreases liquidity in the system which helps increase the federal funds rate, Bieri said. When there’s less money to go around, the cost of borrowing goes up.
“Think of selling securities as a sponge. Because commercial banks pay money for these securities, they hand liquidity to the Fed,” Bieri said.
And finally, the Fed adjusts the “discount rate” as needed. That is the rate it charges to banks for loans taken through its discount window. This is typically used as a “last resort for banks that weren’t able to borrow from other banks or had insufficient cash on hand,” according to the Federal Reserve Bank of St. Louis.
The Federal Reserve also has other tools at its disposal to indirectly exert influence on other interest rates. “Fedspeak,” or a simple announcement, can indirectly affect rates. The Fed can also buy and sell longer-dated Treasury securities to influence rates.
After a year of not adjusting the federal funds rate, the Fed will likely dig into its toolbox and finally make a cut in a couple of months. The amount of interest you get on your savings will probably eventually go down, but borrowing a car will get cheaper.