Barnett and Company

Personal Finance: How does the Fed control interest rates?

At last week’s press conference, Fed Chairman Jerome Powell hinted that the central bank would reduce interest rates in the near future. While the wisdom of increasing emergency monetary policy is debatable during the longest expansion in postwar history, the question arises: exactly how does the Fed exert control over interest rates?

The Federal Reserve System was created in 1913 by the Federal Reserve Act. The system consists of a semi-independent Board of Governors appointed by the president and confirmed by the Senate, and 12 regional Federal Reserve Banks. The regional banks are private entities, owned by commercial banks that belong to the Federal Reserve System.

The Fed receives no taxpayer funds and is entirely self-supported by interest income on its portfolio plus fees from member banks. Any profit remaining after expenses must be turned over to the U.S. Treasury.

The primary mandate of the Federal Reserve is to maintain appropriate monetary policy (money supply and credit) and to serve as a lender of last resort to member banks.

In the past, the preferred channel through which the central bank operated was manipulation of the money supply. However, the proliferation of alternative payment systems made it difficult to measure, much less control, the quantity of money, and the Fed abandoned monetary targeting in 2000. Today, the main target is interest rates.

How do they do it? First, the Fed determines how much member banks must set aside as reserves and the interest rate paid on those reserves. Second, the reserve banks may lend to their member banks at a rate known as the Discount Rate, again set by the Board of Governors.

Third, the Federal Reserve engages in market transactions in order to affect another key interest rate called the Federal Funds rate. This is the rate at which member banks may borrow from each other at the end of the day to satisfy their reserve targets with the Fed. Banks with surpluses lend to banks seeking additional capital (typically overnight) at the Fed Funds rate.

Here is where it gets interesting. Unlike the Discount Rate, the Fed cannot set the Fed Funds rate by fiat, and must engage in what are called “open market operations.” The board can influence that short-term rate by buying or selling government securities in the open market, affecting the price and therefore, the yield or interest rate in the marketplace.

Suppose the U.S. economy is entering a recession (think 2008). To stimulate growth, the Fed wishes to coax interest rates lower by cutting the Fed Funds rate and encouraging more borrowing. In that case, the Federal Open Market Committee (a subgroup of the Fed) will buy U.S. government securities from member banks on the open market and deposit the proceeds in the bank’s account at the Fed. That action reduces banks’ need for Fed Funds, driving the rate lower. This ultimately affects other lending rates like the 10-year Treasury bond yield. The massive run-up in the Fed’s portfolio following the financial crisis was an extreme case of expansionary open market operations.

To combat inflation and cool the economy, the Fed sells securities and debits the banks’ reserve accounts, causing the Fed Funds rate to rise and lending to decline in the economy. Those open market operations are the central bank’s most powerful tool.

Many observers remain concerned that the already-low Fed Funds rate (2.5%) is unwarranted during a period of record-low unemployment, and find the signal from Chairman Powell regarding imminent cuts confounding. Be that as it may, if they decide to move, you know how they do it.

Christopher A. Hopkins, CFA
Vice President and Portfolio Manager
Barnett & Company

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