A beginner’s guide to how the FED sets rates

You may have heard the phrase “Do not fight the Fed” many times reading financial news and while seemingly innocuous, this simple term describes the relationship between the Fed’s decision, the direction of the short-term rates and the perceived performance of the markets. Before we get into the nitty-gritty of how the Fed sets the interest rates, let’s go over quickly who and what body makes these decisions.

A short introduction to the FED

According to the Fed’s official website, “The Federal Open Market Committee (FOMC) consists of twelve members–the seven members of the Board of Governors of the Federal Reserve System; the president of the Federal Reserve Bank of New York; and four of the remaining eleven Reserve Bank presidents, who serve one-year terms on a rotating basis.” The monetary policy-setting group holds 8 regularly scheduled meetings during the year, and other meetings as needed.”

You may not realize it but the Federal Reserve behind closed doors is influencing your everyday life. Over the past 100 years, the Fed has worked to keep the U.S. financial system stable and soften the effects of financial disasters as much as possible. Its services and decisions affect our day-to-day lives, indirectly influencing everything from stock prices and interest rates on loans, like mortgages, to the employment rate and how much consumers spend. Ok, wait, but this sounds like a big job, so how does the Fed influence the interest rates?

Monetary policy

The Fed influences the amount of money and credit in the U.S. economy through what is called “monetary policy”. The goals of monetary policy are to promote maximum employment, stable prices, and moderate long-term interest rates. The Fed’s instruments of monetary policy roughly fall into 4 buckets: target Fed Fund rate, open market operations, the discount rate, and reserve requirements.

1. The Fed implements monetary policy primarily by influencing the Federal funds rate, the interest rate that financial institutions charge each other for loans in the overnight market for reserves.

2. Open market operations (OMO) refers to when the Federal Reserve buys and sells primarily U.S. Treasury securities on the open market in order to regulate the supply of money that is on reserve in U.S. banks, and therefore available to loan out to businesses and consumers. It purchases Treasury securities to increase the supply of money and sells them to reduce the supply of money.

3. The discount rate, by contrast, is the interest rate charged by the Federal Reserve for discount loans. As such, it is not market-determined but rather set by the Federal Reserve.

4. Reserve requirements are the portions of deposits that banks must maintain either in their vaults or on deposit at a Federal Reserve Bank.

A complicated but necessary organization

In the simplest terms, the Fed uses an expansionary monetary policy when the economy is shrinking, the growth is stalled and unemployment is a problem and therefore engages in actions to increase money supply. To increase the money supply, the Fed can buy government bonds (OMO), lower the target Fed Fund rate and discount rate and lower the reserve ratio. The changes in the money supply affect the economy through a 3 step process. An increase in the money supply causes interest rates to fall, the decrease in interest rates causes consumption and investment spending to rise and so aggregate demand rises and the increase in aggregate demand causes real GDP to rise.

A recent example can be seen in actions taken by the Fed to support the economy in response to the Covid-19 crisis. The Fed has cut its target for the Fed Fund rate by a total of 1.5 percentage points since March 3, bringing it down to a range of 0% to 0.25%. This rate is a benchmark for other short-term rates, and also affects longer-term rates, so this move is aimed at lowering the cost of borrowing on mortgages, auto loans, home equity loans, and other loans, but it will also reduce the interest income that savers get. Additionally, the Fed has lowered the discount rate by 2% to 0.25%, lower than the Great Depression, to encourage lending and spending by consumers and businesses.

The Fed’s work is complicated, and consequently often misunderstood. But it isn’t something to pass up because at the end of the day its actions and inactions impact our daily lives—affecting everything from how much we pay on our debt, to how much we earn on our savings, to how well our investments perform, and much more.

What former Fed Chairman Ben Bernanke once said truly captures the essence of our educational blog:

“Economics is a very difficult subject. I’ve compared it to trying to learn how to repair a car when the engine is running.” and “Developments in financial markets can have broad economic effects felt by many outside the markets.”

Sources: federalreserveeducation.org, federal reserve Bank of San Francisco/education, newyorkfed.org, Investopedia.com, wsj.com, goodreads.com

_{Disclaimer: This article has been distributed for educational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy, or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.}