The Federal Reserve and Interest Rates
Reasonable interest rates are the cornerstone of
banking and the economy. Without interest, there would
be no incentive to loan money or save in banks. Over
the centuries, borrowing has become more sophisticated
and complex. A single percentage point can influence
billions of dollars in commerce.
The government is aware of just how critical borrowing is
to our economy and put the U.S. Federal Reserve in
charge of influencing market interest rates. It knows that
by changing rates, it can help America avoid dips in the
economy and even jumpstart it out of a depression.
What Interest Rates Mean for the Economy
The growth of the economy is based largely on how
cheap it is to borrow money. The lower the interest rates
on a loan, the cheaper it is for people and businesses to
borrow money for expansion and large purchases. If a
bank charged 30 percent interest on a loan, individuals
would not be able to afford mortgages for houses and
only a few startup businesses would be funded.
However, if banks issued loans at 1 percent, people
would be willing to try riskier business ventures and
spend more money on their homes.
Though there are an incalculable number of factors at
work in an economy, the average interest rate is among
the most influential. When the economy needs help, the
government looks to the Federal Reserve to change its
policies and adjust interest rates.
The Federal Reserve
The Federal Reserve, informally referred to as “the Fed,”
was established in 1913 and consists of 12 regional
reserve banks spread throughout the country. Aside
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from regulating bank deposits, the Fed also determines
the country’s monetary policy.
The Fed requires all commercial banks to hold a certain
percentage of all their accounts value in cash at their
regional federal reserve bank. This prevents banks from
loaning out too much money and not being able to pay
for customers withdrawing cash or closing accounts.
The Federal Funds Rate
Banks do not like to keep extra money lying around;
cash kept with the Fed could be loaned out and earning
interest. As a result, a bank will try to keep as little
money on account with the Fed as possible. However, if
the bank has a busy day, it may suddenly find it needs
more money in its federal deposit to meet Fed
regulations.
When the economy needs help, the
government looks to the Federal Reserve to
change its policies and adjust interest
rates.
Fortunately, when a bank needs a larger deposit at the
Fed, it can ask to borrow the extra money from another
bank that has a surplus in its Fed account (typically the
loan just lasts overnight).
The federal funds rate is simply the target loan rate the
Fed would like to see banks using when borrowing with
each other.
This article was written by Advicent Solutions, an entity unrelated to Northern Oak Wealth
Management, Inc.. The information contained in this article is not intended to be tax, investment, or
legal advice, and it may not be relied on for the purpose of avoiding any tax penalties. Northern Oak
Wealth Management, Inc. does not provide tax or legal advice. You are encouraged to consult with
your tax advisor or attorney regarding specific tax issues. ©2013, 2016 Advicent Solutions. All rights
reserved.
Changing the Rate
Since the Fed cannot enforce the rate private banks loan
money at, it will change in the public money supply until
the market determines a rate close to the target rate.
How? When the Fed sets a lower target funds rate, it
buys U.S. Treasuries from the public. This increases the
money in circulation, much of which gets deposited into
commercial banks by individuals. With more cash on
hand at banks, the number of banks with surpluses
increases and the demand for overnight loans drops.
With more surplus accounts, banks still needing loans
can negotiate a lower rate. The Fed continues to add
money until the actual loan rate matches the target.
Correspondingly, when the target rate is raised, the Fed
will sell U.S. Treasuries (or other securities) and remove
money from circulation. This creates higher demand for
overnight loans and causes banks to raise their actual
loans rates.
Just as increases or decreases in money supply cause
banks to loan each other money at different rates, they
also change the rate at which the banks will make loans
to people. The easier it is for a bank to get money, the
more willing it is to loan it out to the public.
The Federal Discount Rate
In addition to borrowing money from one another, banks
are allowed to borrow money directly from the Fed (often
called “using the Fed window.”) The rate at which the
Fed loans out money is called the federal discount
rate. This rate is often used synonymously with the
federal funds rate, but they are not the same. The
federal discount rate is typically between 0.25-1.00
percent higher than the federal funds target rate. The
discount rate and Fed window ensures that banks
always have a source of loans and prevents banks from
charging each other too much.
Goals of Adjusting the Federal Funds Rate
The main purpose of increasing or decreasing the
federal funds rate is to control how easy it is for the
public to get loans. Cheap loans encourage businesses
to expand and people to buy long-term goods like
houses and cars. Easy access to loans gets more
money flowing in the economy and puts more people to
work.
During times of economic contraction or underperformance, the Fed’s first step will usually be to lower
the funds rate. The hope is that cheaper money will
encourage people to spend more money and stimulate
the economy before too many jobs are lost.
When the economy is severely depressed, low rates
help start-up businesses get cheap loans and create
new jobs. Low loan rates also translate to low incentives
for saving, encouraging individuals to put their money to
work by investing in companies.
Raising the rates is also a necessary function. After an
economy has recovered, it can become overheated if
rates stay low and money is too easy to get. When too
much money is passed around too quickly, inflation
climbs significantly. By raising rates and withdrawing
money from the market, the Fed can slow things down
and keep prices from getting out of hand.
Though the manipulation of interest rates has its critics
and seems unnatural in a free market, the Fed’s goal for
the federal funds rate is always to support a smooth
economy and keep people employed. Since the
productivity of American workers is what gives the dollar
its value, keeping the economy strong is key to our
international wealth.
Future Changes
The future of the federal funds rate remains unclear. The
Fed has never needed to keep interest rates as low as
they have been in recent years. Though the federal
funds rate can be increased if we need it to combat
inflation, no one is certain what impact repeated interest
rates hikes will have on the economy.
Eventually, the target rate will be raised to normal levels
for one reason or another; hopefully, because low rates
are no longer needed. As the economy changes, the
Fed may create new regulations and strategies, but it will
always adjust its plans to promote prosperity.