How Does the Fed Raise or Lower Interest Rates?

how does the fed 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. Photo by 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. This is the interest rate that 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 to do so from each other.

Since the banks set the rate, the Fed is actually setting a target for this important interest rate. By law, the banks can actually set any rate they want. However, this is rarely a problem. They normally meet the Fed's target because the Fed gives them several strong incentives to do so.

The biggest incentive is open market operations. That's when the Fed buys or sells securities, usually U.S. Treasurys, from its member banks. In return, it adds or subtracts a credit to 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. It 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 nothing at all.

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, or banks will simply borrow from the Fed.

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 zero to .25 percent. In December 2015, it raised it 1/4 point to 0.5 percent. A year later, it increased it to 0.75 percent. The current fed funds rate is 1.25 percent.

The crisis in 2008 was so grave that it needed to great 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 percent, well within the Fed's target. (Source: "The Man Behind Rate Liftoff," The Wall Street Journal, November 24, 2015.)

Since banks have plenty of funds, they don't have much incentive to borrow from each other to meet the reserve requirement. Therefore, 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.  (Source: "Why Did the Federal Reserve Start Paying Interest Rates on Reserves?" Federal Reserve Bank of San Francisco.)

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. However, the Emergency Economic Stabilization Act of 2008 moved it up to October 1, 2008, in response to the financial crisis. (Source: "Interest on Required Balances and Excess Reserves," Board of Governors of the Federal Reserve System.)

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.