How Does the Fed Raise or Lower Interest Rates?

Federal Reserve Board Chairman Ben Bernanke (R) chats with former Federal Reserve Chairman Alan Greenspan during the Federal Reserve centennial commemoration at the Federal Reserve building, on December 16, 2013 in Washington, DC.
•••

Mark Wilson/Getty Images

The Federal Reserve raises or lowers interest rates through its regularly scheduled Federal Open Market Committee. That's the monetary policy arm of the Federal Reserve Banking System.

The FOMC sets a target for the fed funds rate after reviewing current economic data. The fed funds rate is the interest rate banks charge each other for overnight loans. Those loans are called fed funds. Banks use these funds to meet the federal reserve requirement each night. If they don't have enough reserves, they will borrow the fed funds needed.

Since the banks set the rate, the Fed is actually setting a target for the fed funds rate. By law, the banks can set any rate they want. But this is rarely a problem for the Fed. Banks meet the Fed's target because the nation's central bank gives them several strong incentives to do so.

Key Takeaways

  • The Fed changes the money supply by adjusting the target fed funds rate
  • The Fed uses monetary tools such as the reserve requirement, discount rate, and open market operations to encourage banks to reach its target rate
  • The Fed created a new monetary tool called reverse repos to further manage the target fed funds rate

How the Fed Convinces Banks to Raise Their Rates

The Fed's biggest incentive is open market operations. That's when the Fed buys or sells securities, most often U.S. Treasurys, from its member banks. In return, it adds credit to or subtracts credit from the banks' reserves. 

If the Fed wants to lower the fed funds rate, it takes securities out of the bank's reserves and replaces them with credit.

That's just like cash to a bank. Now the bank has more than enough reserves to meet its requirement. The bank lowers its fed funds rate to lend the extra reserves to other banks. It will drop the rate as low as necessary to get rid of excess reserves. It would rather make a few cents lending it than have it sit on its ledger earning nothing.

The Fed does the opposite when it wants to raise rates. It adds securities to the bank's reserves and takes away credit. Now the bank must borrow fed funds to make sure it has enough on hand to meet the reserve requirement that night. If enough banks are borrowing, those that can lend extra fed funds will raise the fed funds rate.

The Federal Reserve Bank of New York has a trading desk that engages in open market operations every day. Two floors of traders and analysts monitor interest rates all day. For the first part of the morning, they adjust the level of securities and credit in banks' reserves to keep the fed funds rate within the targeted range. 

The Fed sets a ceiling for the fed funds rate with its discount rate.

That's what the Fed charges banks who borrow directly from its discount window. The Fed sets the discount rate higher than the fed funds rate. It would prefer banks to borrow from each other. The discount rate sets an upper limit on the fed funds rate. No bank can charge a higher rate. If they do, other banks will simply borrow from the Fed.

The chart below shows the change in the discount rate and the federal funds rate from 2009 through 2020.

The Financial Crisis Changed How the Fed Raises Rates

The Fed had to use extraordinary measures to restore liquidity in the financial crisis. In late 2008, the Fed lowered the target for the fed funds rate to a range of between 0% and 0.25%. It kept it there until the recession was safely over.

After the recession, the Fed raised rates to a post-recession high of 2.5% in December 2018. In March 2020, it lowered it to a range of between 0% and 0.25%,. Its current fed funds rate is in response to the global COVID-19 pandemic.

The crisis in 2008 was so grave that the Fed needed to greatly expand its open market operations to add more liquidity.

Over the next six years, quantitative easing added $2.6 trillion in credit to the banks' reserves. Banks no longer had to borrow from each other to meet the reserve requirement. Everyone had plenty of funds. This kept the rate at around 0.13%, well within the Fed's target. 

When banks have plenty of funds, they don't have much incentive to borrow from each other to meet the reserve requirement. As a result, the Fed can raise two other bank rates.

Rates on Reserves

First, it will raise the interest rate it pays on required and excess reserves. Banks won't lend money to each other for a lower interest rate than they are already receiving for their reserves. That sets a floor for the fed funds rate.

Congress gave the Fed this authority in the Financial Services Regulatory Relief Act of 2006. Banks complained they were penalized because they received no interest for their reserves. Initially, it was supposed to become effective on Oct. 1, 2011.  But the Emergency Economic Stabilization Act of 2008 moved it up to Oct. 1, 2008, in response to the financial crisis.

Rates on Reverse Repos

Second, the Fed will raise the interest rate on reverse repos. That's a new tool the Fed created to control the fed funds rate. The Fed "borrows" money from its member banks overnight. It uses the Treasurys it has on hand as collateral. It's not a real loan because no cash or Treasurys change hands. But, the Fed does deposit the interest into the banks' accounts the next day. This controls the fed funds rate because banks won't lend to each other at a lower rate than what they're getting on the reverse repos. 

Article Sources

  1. Board of Governors of the Federal Reserve System. "Federal Open Market Committee," Accessed May 11, 2020.

  2. Federal Reserve Bank of St. Louis. "Effective Federal Funds Rate," Accessed May 11, 2020.

  3. Federal Reserve Bank of St. Louis. "A Closer Look at Open Market Operations," Accessed May 11, 2020.

  4. Federal Reserve Bank of New York. "Open Market Operations," Accessed May 11, 2020.

  5. Board of Governors of the Federal Reserve System. "Credit and Liquidity Programs and the Balance Sheet," Accessed May 11, 2020.

  6. Federal Reserve Bank of San Francisco. "U.S. Monetary Policy: An Introduction," Accessed May 11, 2020.

  7. Federal Reserve Bank of St. Louis. "Daily Fed Funds Rate," Accessed May 11, 2020.

  8. Federal Reserve Bank of St. Louis. "Effective Federal Funds Rate," Accessed May 11, 2020.

  9. Gale. "Needed: A Federal Reserve Exit From Preferential Credit Allocation," The Cato Journal (Vol. 36, Issue 2), Page 353. Accessed May 11, 2020.

  10. Board of Governors of the Federal Reserve System. "Interest on Required Reserve Balances and Excess Balances," Accessed May 11, 2020.

  11. Federal Reserve Bank of San Francisco. "Why Did the Federal Reserve Start Paying Interest on Reserve Balances Held on Deposit at the Fed? Does the Fed Pay Interest on Required Reserves, Excess Reserves, or Both? What Interest Rate Does the Fed Pay?" Accessed May 11, 2020.

  12. U.S. Congress. "S.2856 - Financial Services Regulatory Relief Act of 2006," Accessed May 11, 2020.

  13. U.S. Congress. "Financial Services Regulatory Relief Act of 2006," Sec. 128. Acceleration of Effective Date. Accessed May 11, 2020.

  14. U.S. Congress. "Division A — Emergency Economic Stabilization," Accessed May 11, 2020.

  15. Federal Reserve Bank of New York. "Repo and Reverse Repo Agreements," Accessed May 11, 2020.

  16. Federal Reserve Bank of New York. "FAQs: Reverse Repurchase Agreement Operations," Accessed May 11, 2020.