How Does the Central Bank Change Interest Rates?

how does the fed change interest rates in the banking system

If you’ve ever bought a house, bought something with a credit card, or borrowed money for any number of business or daily living expenses, you know how much interest rates can affect your finances. But do you know how the central bank is involved in determining interest rates? Learning about the inner workings of the Federal Open Market Committee and monetary policy can help you understand – and even predict – changing interest rates and their economic impact.

What is the Federal Open Market Committee (FOMC) and What is Its Role in Monetary Policy?

What is the Federal Open Market Committee (FOMC) and What is Its Role in Monetary Policy?The Federal Open Market Committee (FOMC) sets the target range for the federal funds rate, which is the interest rate that banks charge each other for overnight loans. The Federal Reserve then uses its monetary policy tools to implement the new stance of policy set by the FOMC and ensure that market interest rates, including the federal funds rate, move in the direction of the new target range. This helps steer the economy towards the Fed’s dual mandate goals of price stability and maximal employment.

What Are the Key Tools of Monetary Policy Used by the Federal Reserve?

The key tools of monetary policy used by the Federal Reserve are administered rates, which include interest on reserve balances, the overnight reverse repurchase agreement facility, and the discount rate. Additionally, the Fed uses open market operations to maintain ample reserves in the banking system and ensure that its administered rates are effective.

What is Interest on Reserve Balances and Why is It the Primary Tool for Adjusting the Federal Funds Rate?

What is Interest on Reserve Balances and Why is It the Primary Tool for Adjusting the Federal Funds Rate?

Interest on reserve balances is the interest paid on funds that banks hold in their reserve balance accounts at the Federal Reserve bank. It serves as a “reservation rate”, the lowest rate at which a bank will be willing to lend its funds, and therefore should not fall below the federal funds rate. The Fed can steer the federal funds rate by adjusting the interest on reserve balances rate, which is why it is the primary tool for adjusting the federal funds rate.

What Is the Overnight Reverse Repurchase Agreement Facility and What Is Its Role in Setting a Floor for the Federal Funds Rate?

Not all financial institutions that operate in the federal funds market can earn interest on their reserve balances. To provide support, the Fed offers the overnight reverse repurchase (ON RRP) agreement facility to a broader set of large financial institutions, allowing them to earn the overnight reverse repurchase agreement offering rate by depositing funds with the Fed. 

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The ON RRP is like a savings account for big banks. Imagine you have some cash you don’t need right away, and you want to earn some interest on it. So, you deposit that money into a savings account. Big banks can do the same thing with the ON RRP, which is run by the Federal Reserve. By depositing their extra money into the ON RRP, the big banks earn a higher interest rate and help the Federal Reserve keep the federal funds rate within a target range. This helps the Federal Reserve steer the economy in the direction it wants.

What Is the Discount Rate and What Is Its Role as a Ceiling for the Federal Funds Rate?

What Is the Discount Rate and What Is Its Role as a Ceiling for the Federal Funds Rate?The discount rate is the interest rate charged by the Fed for loans it makes through the Fed’s discount window. Because banks are unlikely to borrow at a higher rate than they can borrow from the Fed, the discount rate acts as a ceiling for the federal funds rate.

Why Is the Federal Funds Rate Relevant to You?

The central bank’s influence on interest rates has a huge impact on investors, business owners, families, and consumers. Understanding monetary policy can help you make better decisions about your investments and manage your personal finances effectively. Getting a solid grasp of these systems can be a challenge, but a qualified financial adviser can help. Financial planners and advisers make it their business (literally) to understand the federal funds rate and use it to their client’s advantage – so that you can have greater returns on your investments and build lasting financial security. Don’t wait to talk to an expert. Securing your financial future starts now.   

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Sources and Further Reading

- Federal Reserve Economic Data - Economic Research

- A History of Interest Rates (2005), Sidney Homer.

- "A Theory of the Term Structure of Interest Rates", John C Cox, Jonathan E. Ingersoll. The Econometric Society – Econometrica (Vol. 53 No. 2)