How Does the Fed Raise or Lower Interest Rates?

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The Federal Reserve raises or lowers interest rates through the Federal Open Market Committee (FOMC). The Committee conducts open market operations for the Federal Reserve System.

After reviewing current economic data, the FOMC sets a target for the fed funds rate at one of its eight meetings. But what are fed funds, and how do they influence interest rates?

Key Takeaways

  • The Fed sets a target for the fed funds rate. At its July 27-28, 2021, meeting, the FOMC said it would maintain the target fed funds rate at a range of 0% to 0.25%.
  • By law, banks set their own effective fed funds rate.
  • The Fed heavily influences this rate using open market operations, the reserve requirement, and the discount rate.
  • The Fed can also pay interest on bank reserves and purchase repos or reverse repos to fine-tune interest rates.

How the Fed Convinces Banks to Raise Their Rates

The Fed typically requires banks to hold a percentage of their deposits in reserves each night. If they don't have enough reserves, they will borrow what's needed.

Banks charge interest rates when giving other banks overnight loans. Those loans are called fed funds. Banks use the fed funds to meet the reserve requirement each night.

The actual rate that banks set is called the effective fed funds rate. The Fed can only set a target for the fed funds rate as banks are private businesses that can set any rate they wish.

In March 2020, the FOMC reduced the reserve requirement to effectively zero, which it will retain until it is "confident that the economy has weathered recent events and is on track to achieve its maximum employment and price stability goals."

Unless something is really wrong, banks meet the Fed's target because the nation's central bank gives them several strong incentives to do so.

Open Market Operations

The Fed's buying or selling of securities (Treasury notes or mortgage-backed securities) from its member banks is called open market operations. In return, the Fed adds credit to or subtracts credit from the banks' reserves. 

The FOMC directs the Federal Reserve Bank of New York to execute open market operations transactions.

If the Fed wants to lower the fed funds rate, it takes securities out of the bank's reserves and replaces them with credit, which is like cash to a bank. Now the bank has more than enough reserves to meet its requirement. In March 2020, the Fed announced that it would increase Treasury security holdings by at least $500 billion and mortgage-backed securities by $200 billion.

The member bank lowers its effective fed funds rate to lend extra reserves to other banks—as much as necessary to get rid of excess reserves. The bank would rather make a few cents lending the reserves than have reserves sitting on its ledger, earning nothing.

To raise rates, the Fed takes the opposite steps. It adds securities to the bank's reserves and takes away credit. Now, the bank must borrow fed funds to ensure it has enough on hand to meet any 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 daily open market operations. 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.

Quantitative Easing

Quantitative easing (QE) is an expansion of open market operations and only used during financial crises, after the FOMC has lowered the fed funds rate to zero.

The Fed buys massive amounts of securities from its member banks to keep Treasury yields low. In 2008, QE increased total assets to $2.2 trillion. In 2020, it topped $7.2 trillion.

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 to manage interest rates.

The chart below shows the relationship between total assets and total reserves from 2007 through 2021.

Interest Rates on Bank Reserves

The Fed can raise interest rates by increasing 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. The Emergency Economic Stabilization Act of 2008 allowed the Fed to pay interest on reserves.

Rates on Reverse Repos

The Fed can also raise the interest rate on reverse repurchase agreements, known as reverse repos. The Fed "borrows" money from its member banks overnight, using the Treasurys it has on hand as collateral. It's not a real loan because no cash or Treasurys change hands.

The Fed deposits 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.

Discount Rate

The Fed charges a discount rate to banks who borrow directly from its discount window. The Fed sets the discount rate higher than the fed funds rate because it prefers banks to borrow from each other. By doing so, 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.

In March 2020, the Fed announced changes to encourage the use of its discount window including lowering rates and lengthening the borrowing period.

The chart below shows the changes in the discount rate and the federal funds rate from 2000 through 2021.

Adjusting Reserve Requirement Ratios

The Fed can also raise or lower interest rates by adjusting reserve requirement ratios. A higher requirement means banks have to keep more money on hand, giving them less to lend. This raises interest rates. A lower requirement does the opposite—they can keep less money on hand and lend out more.

The Fed rarely changes the requirement since other tools are much easier for banks to implement. That's why it was so unusual when it reduced reserve requirements to zero effective March 26, 2020. That assures that banks will keep the effective fed funds rate at virtually zero, allowing them to lend out more money.