How Does the Fed Raise or Lower Interest Rates?
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 this important interest 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.
How the Fed Convinces Banks to Raise Their Rates
The 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 does this every day. Two floors of traders and analysts monitor interest rates all day. For the first 30 minutes each 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 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 2019.
How the Financial Crisis Changed the Way the Fed Raises Rates
The Fed had to use extraordinary measures to restore liquidity in the 2007 banking crisis. In late 2008, the Fed lowered the fed funds rate to 0.25%. That's effectively zero. It kept it there until the recession was safely over.
In December 2015, it raised the rate to 0.5%. In 2016, it raised it to 0.75%. The Committee raised the rate three times in 2017. The Fed continued to raise rates slowly until it reached the current fed funds rate
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.
Since 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 will do two other things to raise rates.
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 became effective on October 1, 2011. But the Emergency Economic Stabilization Act of 2008 moved it up to October 1, 2008, in response to the financial crisis.
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.