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Why You Should Care
What happens in the U.S. economy has always been influenced and to a degree controlled by the Fed. Most recently, the Fed, by necessity and somewhat by choice, has become much more involved in trying to manage and stabilize economic outcomes. You should watch what the Fed says and does, and think through the long-term consequences of its economic policies and actions. It’s also worth understanding the credit and banking protections the Fed has put in place.
31. TARGET INTEREST RATES
Central to the task of the Federal Reserve and other central banks is to manage the nation’s money supply and to stimulate or slow down economic activity to stabilize prices, maintain employment, and foster moderate economic growth. Central banks use target interest rates as well as direct injections of money into the financial system to moderate interest rates and to accomplish these other economic goals.
Interest rates work like a brake or accelerator on an economy. Lower rates make money “cheaper”—that is, cheaper to borrow, and thus more available for economic activity. Conversely, higher interest rates make money more expensive, thus acting as a brake on the economy, which ultimately helps to control inflation.
What You Should Know
Every economy has target interest rates managed through central bank policy. In the United States, the Fed controls the discount rate directly, and manages the federal funds rate, or “Fed funds rate,” through open market operations (see #32 Fed Open Market Operations). In Europe, the LIBOR, or London Interbank Offered Rate, is the primary target interest rate.
The Fed funds rate is more important—and more complicated—than the discount rate, and is a key component of monetary policy. Specifically, it’s the rate that banks charge each other for overnight loans of reserves they hold at the Fed. The Fed does not actually set this rate, but rather influences and controls it by changing the money supply through open market operations. When the Federal Open Market Committee meets, as it does eight times a year, it sets the target for the Fed funds rate, leaving it unchanged, or raising or lowering it, usually in increments of 0.25 or 0.50 percent. Open market operations do the rest. The Fed funds rate is the most important and most closely watched tool in the Fed’s policy arsenal, and it becomes the base for many other interest rates throughout the economy, including the prime rate (see #22 Prime Rate), which is typically about 3 percent above the Fed funds rate.
In the Great Recession and its aftermath the Fed was so concerned about propping up the economy that it lowered the Fed funds rate to an unprecedented 0.25 percent, and it has ranged between 0 and 0.25 percent ever since. To put that into context, it’s interesting to look at the Fed funds rate over the last fifty-five years:
Figure 4.1 Target Fed Funds Rate, 1954–2009
Source: The Federal Reserve
Figure 4.1 shows pronounced swings in the rate, including a drastic and—in hindsight—somewhat misguided spike in the rate in the early 1980s to mitigate an inflationary spiral that was as much caused by supply constraints (oil) as overheated demand. You can also see the swings over the last twenty-five years as the Fed has tried, with some success, to moderate the business cycle. Finally, although the chart itself has only been updated through 2009, there’s been little reason to update it since, because the effective rate continues to hover near zero.
The discount rate is the rate at which the Fed will lend funds directly to member banks. The Fed sets this rate directly, but sets it usually a percent or so higher than the Fed funds rate to encourage banks to lend to each other instead of borrowing from the Fed.
To understand global credit conditions and interest rates, many now refer to LIBOR, or London Interbank Offered Rate—a composite indicator originating in Europe. LIBOR is similar in effect to the Fed funds rate, but is a composite calculation of rates at which eighteen of the world’s major banks actually do lend to each other, so isn’t a target rate per se. While policy is used to try to influence LIBOR, it is much more a reflection of true lending and credit conditions, and has been adopted worldwide as an indicator. In the fall of 2008, at the height of the banking crisis, LIBOR spiked to stu
Why You Should Care
Target interest rates and the Fed funds rate will ultimately influence the interest rates, especially short-term rates, you will pay on loans or receive as income on deposits. Obviously, they will also affect the economy. Changes in the Fed funds rate are closely watched—as are the accompanying statements by the Fed—for signs of current economic stress and future economic direction.
32. FED OPEN MARKET OPERATIONS
The Fed funds rate is the Fed’s most important tool for influencing economic activity and achieving price stability (see #31 Target Interest Rates). As it is a rate used by banks for lending to each other, the Fed does not control the rate directly, but does it instead through open market operations.
What You Should Know
With open market operations, the Fed adds or subtracts money from the economy, influencing the supply and demand balance for money and thus the interest rate, or price for that money. Open market operations are the method used by the Fed to bring the true Fed funds rate in line with the target rate, as well as to more directly moderate the amount of money in the system.
The operations consist of sale and purchase of mostly short-term U.S. government Treasury securities to and from the banks. If the Fed sells bonds, it drains money from the banks; if it buys bonds, that gives the banks money to lend. That additional money, multiplied through leverage (see #33 Fractional Reserve Banking), puts a lot more money into the financial system. The Fed does not mandate which securities to trade or which banks or dealers it will transact with; the market is “open” for banks and dealers to compete on price. Every day the Fed a
Open market operations are usually very short term, dealing in short-term securities swapped back and forth on an almost overnight basis to fine-tune short-term interest rates. The Fed may also “jawbone” rates in one direction or another by making public statements in combination with actual open market operations. The persistent stimulus accomplished through the quantitative easing (QE3 and QE4) monthly purchase of $85 billion in bonds on the open market—and related publicity—serves as an excellent example.
Why You Should Care
Aside from the resulting influence on market interest rates, open market operations don’t affect you directly. That said, if you were borrowing to buy a house or refinancing between 2011 and 2013, the well-communicated monthly bond-buying activities worked quite well to drive mortgage rates down to fifty-year lows. It’s interesting to realize just how much goes on behind the scenes at the Fed and within the government in general to keep the economy moving in a favorable direction, and to smooth out the bumps. Without these operations we’d be looking at painful economic gyrations between inflation and deflation, or boom and bust, as seen in Figure 3.1.